Financial planning can be more complex than the percentage of sales approach indicates.

Often, the assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows important items to vary without being a strict percentage of sales.

Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and interest expense depends directly on the amount of debt. Debt is still the plug variable. Note that since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The parameter estimates used in the new model are:

Cost percentage 5 Costs / Sales Depreciation rate 5 Depreciation / Beginning fixed assets Interest rate 5 Interest paid / Total debt Tax rate 5 Taxes / Net income Payout ratio 5 Dividends / Net income Capital intensity ratio 5 Fixed assets / Sales Fixed assets ratio 5 Fixed assets / Total assets The model parameters can be determined by whatever methods the company deems appropriate. For example, they might be based on average values for the last several years, industry standards, subjective estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate them.

The Loftis Company is preparing its pro forma financial statements for the next year using this model. The abbreviated financial statements are presented below.

Sales growth Tax rate 20%

34 Income Statement Sales Costs Depreciation Interest Taxable income Taxes Net income Dividends Additions to retained earnings

$780,000 415,000 135,000 68,000

$162,000 55,080

$106,920

$ 30,000 76,920 Balance Sheet Assets Liabilities and Equity Current assets Net fixed assets Total assets

$ 240,000 1,350,000

$1,590,000 Total debt Owners’ equity Total debt and equity

$ 880,000 710,000

$1,590,000

a. Calculate each of the parameters necessary to construct the pro forma balance sheet.

b. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma balance sheet?

c. In this financial planning model, show that it is possible to solve algebraically for the amount of new borrowing.