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Exam 16: Forecasting

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Question 21

Multiple Choice

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Which of the following statements is CORRECT?

A) When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner.
B) When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow.
C) Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process.
D) For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets.
E) Regression techniques cannot be used in situations where excess capacity or economies of scale exist.
Multiple Choice: Problems

F) A) and B)
G) A) and C)

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Question 22

True/False

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Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant.

A) True
B) False

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Question 23

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Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?

A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing.

Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its Fixed Assets/Sales ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target Fixed Assets/Sales ratio should the company set?

Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's additional funds needed (AFN) . Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year?

If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing.

The capital intensity ratio is generally defined as follows:

If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding.

A typical sales forecast, though concerned with future events, will usually be based on recent historical trends and events as well as on forecasts of economic prospects.

When developing forecasted financial statements there are some inputs that management controls such as the growth rate and operating costs/sales ratio, while other inputs such as the tax rate and interest rate are not under its control.

Errors in the sales forecast can be offset by similar errors in costs and income forecasts. Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm.

The term "additional funds needed (AFN) " is generally defined as follows:

The first, and most critical, step in constructing a set of forecasted financial statements is the sales forecast.

Which of the following statements is CORRECT?

To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds.

Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets?

If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant.

When we use the AFN equation to forecast the additional funds needed (AFN), we are implicitly assuming that all financial ratios are constant. If financial ratios are not constant, regression techniques can be used to improve the financial forecast.