3.
MACRS Depreciation Expense and Accounting Cash Flow
Pavlovich Instruments Inc., a maker of precision telescopes, expects to report pretax income of
$430,000 this year. The company’s financial manager is considering the timing for purchase of
new computerized lens grinders. The grinders will have an installed cost of $80,000 and a cost
recovery period of five years. They will be depreciated using the MACRS schedule (see Table
4.2).
a). If the firm purchases the grinders before year’s end, what depreciation expense will it be
able to claim this year?
Depreciation expense: $80000 x 20%
= $16000
The depreciation expense that is able to be claimed this year is $16,000.
b). If the firm reduces its reported income by the amount of the depreciation expense calculated
in part a, what tax savings will result?
Malaysia’s corporate tax = 24%
US’s corporate tax = 21%
Tax Savings = Depreciation Expense × Tax Rate
Malaysia: $16,000 x 24% US: $16,000 x 21%
= $3,840 (Malaysia) = $3,360 (US)
If the firm reduces its reported income by the amount of the depreciation expense calculated in
part a, the firm will save $3,840 / $3,360 in taxes.
7. Finding operating and free cash flow
Consider the following balance sheets and selected data from Keith Corporation's income
statement.
a. Calculate the firm’s net operating profit after taxes (NOPAT) for this year by using the
equation:
NOPAT= EBIT * (1- T)
= 2700 x (1-21%)
= 2700 x 0.79
= $2133
Therefore, the firm’s net operating profit after taxes for this year is $2133.
b. Equation of the firm's operating cash flow (OCF) for the year by using the equation:
OCF= NOPAT + Depreciation
= 2133 + 1600
= $3733
Therefore, the firm’s operating cash flow for this year is 3733 dollars.
c. Calculate the firm’s free cash flow (FCF) for the year by using equation:
FCF= OCF- NFAI- NCAI
NFAI: NFA + Depreciation
NCAI: Current Assets - (Account Payables + Accruals)
NFAI= (14800 - 15000) + 1600
= $1400
NCAI= 8200-6800-[(1600-1500)+(200-300)]
= $1200
FCF= OCF - NFAI - NCAI
= 3733-1400-1200
= $1133
Thus, the firm’s free cash flow for the year is $1133.
d. Interpret, compare, and contrast your cash flow estimates in parts b and c.
Operating cash flow (OCF) is the cash flow a firm generates from its normal operations. The
firm’s Operating Cash Flow (OCF) of $3,733 highlights strong cash generation from core
operations, indicating operational efficiency.
Free Cash Flow (FCF) is the amount of cash flow available to investors (creditors and owners)
after the firm has met all operating needs and paid for investments in net fixed assets and net
current assets. It represents the amount of cash that the business has available for reinvestment
or distribution to shareholders. However, its Free Cash Flow (FCF) is lower at $1,133 due to
significant reinvestments in assets (NFAI = $1,400) and working capital (NCAI = $1,200).
While the positive OCF demonstrates profitability, the reduced FCF reflects the firm’s focus
on sustaining and expanding operations. This balance between generating cash and
reinvestment supports long-term growth but limits immediate discretionary cash for
shareholders.
11. Cash budget: Basic
Farmers Delight Corporation reported sales of $350,000 in June, $380,000 in July, and
$390,000 in August. The forecasts for September, October, and November are $385,000,
$418,000, and $429,000, respectively. The initial cash balance on September 1 is $150,000,
and a minimum of $8,000 should be kept. Use the given information to compile a cash budget
for the months of September, October, and November.
(1) Farmers Delight predicts that 5% of its sales will never be collected, 30% of its sales will
be cash sales, and the remaining 65% will be collected in the following month.
(2) Farmers Delight receives other monthly income of $3,000.
(3) The actual or expected purchases are $150,000, $120,000, and $115,000 for the months of
September to November, respectively, and 50% are paid in cash while the remainder is paid in
the following month. The purchases for August were $120,000.
(4) Monthly rent is $3,500 chargeable only in October and November.
(5) Wages and salaries are 12% of the previous month’s sales.
(6) Cash dividends of $4,600 are declared and will be paid in September.
(7) Long-term loan repayment of principal and interest of $4,700 is due in October.
(8) Additional equipment costing $8,500 is ordered and scheduled to be paid for in cash in
November.
(9) Taxes of $8,250 are due in November.
Total Cash Receipts:
Actual
June ($) July ($) August ($)
Sales forecast 350000 380000 117000
Cash Sales (0.3) 105000 114000 117000
Collections Accounts Receivables:
Lagged 1 month (0.65) 227500 243000
Other income: 3000 3000 3000
Total Cash Receipts 108000 344500 367000
Forecasted
June ($) July ($) August ($)
Sales forecast 385000 418000 429000
Cash Sales (0.3) 115500 125400 128700
Collections Accounts Receivables:
Lagged 1 month (0.65) 253500 250250 271700
Other income: 3000 3000 3000
Total Cash Receipts 372000 328650 403400
September:
Cash Sales (30% of $385,000): $115,500
Collection A/R lagged 1 month (65% of $390,000): $253,500
Other Income: $3,000
Total Cash Receipts = $115,500 + $253,500 + $3,000 = $372,000
October:
Cash Sales (30% of $418,000): $125,400
Collection A/R lagged 1 month (65% of $385,000): $250,250
Other Income: $3,000
Total Cash Receipts = $125,400 + $250,250 + $3,000 = $378,650
November:
Cash Sales (30% of $429,000): $128,700
Collection A/R lagged 1 month (65% of $418,000): $271,700
Other Income: $3,000
Total Cash Receipts = $128,700 + $271,700 + $3,000 = $403,400
Total Cash Disbursements:
Actual Forecasted
Aug ($) Sep ($) Oct ($) Nov ($)
Purchases 120000 150000 120000 115000
Cash Purchases (0.5) 75000 60000 57500
Payment of Accounts Payable: 60000 75000
Lagged 1 month (0.5) 3500 60000
Monthly rent 46800 46200 3500
Wages and salaries 4600 50160
(12% of previous month sales)
Cash dividends 4700
Long term loan repayment of
principal and interest
Additional equipment 8500
Taxes 8250
Total cash disbursement 186400 189400 187910
September:
Cash Purchases (50% of $150,000): $75,000
Payment for A/P lagged 1 month (50% of $120,000): $60,000
Wages and Salaries (12% of August Sales, $390,000): $46,800
Dividends: $4,600
Total Cash Disbursements = $75,000 + $60,000 + $46,800 + $4,600 = $186,400
October:
Cash Purchases (50% of $120,000): $60,000
Payment for A/P lagged 1 month (50% of $150,000): $75,000
Rent: $3,500
Wages and Salaries (12% of September Sales, $385,000): $46,200
Long-Term loan Repayment Of Principal And Interest: $4,700
Total Cash Disbursements = $60,000 + $75,000 + $3,500 + $46,200 + $4,700 = $189,400
November:
Cash Purchases (50% of $115,000): $57,500
Payment for A/P lagged 1 month (50% of $120,000): $60,000
Rent: $3,500
Wages and Salaries (12% of October Sales, $418,000): $50,160
Equipment Purchase: $8,500
Taxes: $8,250
Total Cash Disbursements = $57,500 + $60,000 + $3,500 + $50,160 + $8,500 + $8,250 =
$187,910
Cash Balance:
Sep Oct Nov
Total cash receipts 372000 378650 403400
(-) Total cash disbursements 186400 189400 187910
Net cash flow 185600 189250 215490
+ Beginning cash 15000 335600 524850
Ending cash 335600 524850 740340
(-) Minimum cash balances 8000 8000 8000
Excess cash balance 327600 516850 732340
September:
Net Cash Flow = Total Cash Receipts - Total Cash Disbursements = $372,000 - $186,400 =
$185,600
Beginning Cash = $150,000
Ending Cash = Net Cash Flow + Beginning Cash = $185,600 + $150,000 = $335,600
Excess Cash Balance = Ending Cash - Minimum Cash Balance = $335,600 - $8000 = $327,600
October:
Net Cash Flow = Total Cash Receipts - Total Cash Disbursements = $378,650 - $189,400 =
$189,250
Beginning Cash = $335,600
Ending Cash = Net Cash Flow + Beginning Cash = $189,250 + $335,600 = $524,850
Excess Cash Balance = Ending Cash - Minimum Cash Balance = $524,850 - $8000 = $516,850
November:
Net Cash Flow = Total Cash Receipts - Total Cash Disbursements = $403,400 - $187,910 =
$215,490
Beginning Cash = $524,850
Ending Cash = Net Cash Flow + Beginning Cash = $215,490 + $524,850 = $740,340
Excess Cash Balance = Ending Cash - Minimum Cash Balance = $740,340 - $8000 = $732,340
17. Pro Forma Income Statement
Bells Manufacturing estimates that the sales for the 2023 financial year will be $2.25 million.
No new borrowing was obtained and, therefore, the interest expense remained unchanged at
$24,500. Bells Manufacturing is planning on paying cash dividends of $85,000 during 2023.
Refer to the financial data for the year ended December 31, 2022, while answering the
following:
a. Compile the pro forma income statement for the year ended December 31, 2023, using the
percentage-of-sales method.
Cost of Goods Sold/ Sales= 1100000/1800000
= 0.6111
= 61%
Cost of Goods Sold = 2250000 x 61%
=$1372500
Operating expenses/ Sales= 450000/ 1800000
= 0.25
= 25%
Operating expenses= 2250000 x 125%
= $562500
Bells Manufacturing Income Statement
For the year ended December 31, 2023
$
Sales revenue 2250000
(-) Cost of goods sold 1375000
Gross profits 875000
(-) Operating expenses 562500
Operating profits 312500
(-) Interest expenses 24500
Net profit before taxes 288000
(-) Taxes (NPBTx0.4) 115200
Net profit after taxes 172800
(-) Cash dividends 85000
To retained earnings 87800
b. Compile the pro forma income statement for the year ended December 31, 2023, using the
fixed and variable cost data.
Variable cost: (35000/180000) x 2250000
= $437500
Variable expenses: (295000/180000) x 2250000
= $368750
Bells Manufacturing Income Statement
For the year ended December 31, 2023
$
Sales revenue 2250000
(-) Cost of goods sold
Fixed cost 750000
Variable cost 437500
Gross profit 1062500
(-) Operating expenses
Fixed expenses 155000
Variable expenses 368750
Operating profits 538750
(-) Interest expenses (all fixed) 34500
Net profit before taxes 514250
(-)Taxes (NPBTx0.4) 205700
Net profit after taxes 308550
(-) Cash dividends 85000
To retained earnings 223550
c. As the financial manager, which of the two pro forma statements would you regard as more
accurate? Explain.
Pro forma income statement using fixed and variable cost data.
When the firm has fixed costs, using percent-of-sales method might overstate costs and
understate profits because percent-of-sales approach assumes that all costs move in sync with
sales. Therefore, it is recommended to use fixed and variable components.
22. Integrative: Pro forma statement
Morten Metal Limited has assembled past (2020) financial statements (income statement and
balance sheet follows) and financial projections for use in preparing financial plans for the
coming year (2021).
Information related to financial projections for the year 2021 follows.
(1) Projected sales are $420,000.
(2) Cost of goods sold in 2020 includes $72,000 in fixed costs.
(3) Operating expense in 2020 includes $17,500 in fixed costs.
(4) Interest expense will be $18,000 in 2021.
(5) The firm will pay cash dividend amounting to 25% of net profit after taxes.
(6) Cash and inventories are expected to double.
(7) Marketable securities, long-term debt, and common stock will remain unchanged.
(8) Accounts receivable, accounts payable, and other current liabilities will change in direct
response to the change in sales.
(9) During the year, the firm will purchase a delivery vehicle costing $25,000. The depreciation
expense on the new vehicle for 2021 will be $7,000.
(10) The tax rate will remain at 25%.
a. Prepare a pro forma income statement for the year ended December 31, 2021, using the fixed
cost data given to improve the accuracy of percent-of-sales method.
Percent-of-sales method:
Cost of goods sold/ Sales: (192500-72000)/ 350000
= 0.34
Operating expenses/ Sales: (59500-17500)/ 350000
= 0.12
Pro Forma Income Statement- Morten Metal Limited
For the year ending December 31, 2021
$
Sales 420000
(-) Cost of goods sold (fixed) 72000
(-) Cost of goods sold (0.34xsales) 142800
Gross profits 205200
(-) Operating expenses (fixed) 17500
(-) Operating expenses (0.12xsales)+7000 57400
Operating profits 130300
(-) Interest expenses 18000
Net profit before taxes 112300
(-) Taxes (25%xNPBT) 28075
Net profit after taxes 84225
(-) Cash dividends 21056
To retained earnings 63169
b. Prepare a pro forma balance sheet as of December 31, 2021, using the information provided
and the judgmental approach. Include a reconciliation of retained earnings account.
Pro Forma Balance Sheet- Morten Metal Limited
As of December 31, 2021
Assets $ Equity and liabilities $
Cash 32400 Accounts payable 60000
Marketable securities 15500 Taxes payable 6600
Accounts receivable 52440 Other current liabilities 16560
Inventories 70000 Total current liabilities 83160
Total current assets 170340 Long-term debt 36000
Net fixed assets 130000 Total liabilities 119160
Common stock 52000
Retained earnings 127169
External funding required 2011
Total assets 300340 Total equity and liability 300340
Cash: 16200x2 Accounts payable 50000x1.2
Accounts receivable: 43700x1.2 Other current liabilities: 13800x1.2
Inventories: 35000x2 Change in sales: 420000/350000 =1.2
Net fixed assets: 112000+25000-7000
Reconciliation of Retained Earnings
Beginning retained earnings $127169
+ Net profit after taxes 84225
(-) Dividends 21056
Ending retained earnings 190338
c. Analyse these statements, and discuss the resulting external financing required.
The pro forma income statement highlights a profit of $63,169, suggesting that Morten Metals
Limited is positioned for profitability.
The pro forma balance sheet proves that Morten Metals Limited has invested in assets aligned
with its operational needs and growth strategy.
The external funding required of $2,011 indicates a shortfall in internal funding for 2021. It
shows that internal cash flow from operations and retained earnings were insufficient to fully
cover the company’s asset growth or operating needs. To help reduce reliance on external funds
in the future, the firm should adjust operating expenses or assets investments, thereby
strengthening its capacity to fund growth internally.
