Financial planning can be more complex than the percentage of sales approach. Often, the assumptions behind the percentage of sales approach may be incorrect. For example, if the amount of fixed assets increases, then depreciation will increase. A more sophisticated model allows these input variables to vary rather than being a strict percentage of sales.

This model used new borrowing as the plug variable by setting total liabilities and owners$$ equity equal to total assets. Next, the ending amount of owners$$ equity is calculated as the beginning amount plus the additions to retained earnings. The difference between these amounts is the total debt necessary to balance the balance sheet.

The main difference between this model and the percentage of sales approach is that we have separated out depreciation and interest. Depreciation is calculated as a percentage of beginning fixed assets, and the amount of interest depends on the amount of debt. However, since depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer constant.

The model parameters can be based on a percentage of sales model, or they can be determined by other means 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 parameter estimates used in this calculation of proforma financial statements are:

Cost percentage $=$ Costs$/$Sales

Depreciation rate $=$ Depreciation $/$ Beginning fixed assets

Interest rate $=$ Interest paid $/$ Total debt

Effective tax rate $=$ Taxes $/$ Taxable income

Payout ratio $=$ Dividends $/$ Net income

Capital intensity ratio $=$ Fixed assets $/$ Sales

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

Sales growth $22\%$

Tax rate $21\%$

Income Statement

Sales $ $880,000\mathrm{.}00$

Costs $465,000\mathrm{.}00$

Depreciation $112,500\mathrm{.}00$

Interest $88,000\mathrm{.}00$

Taxable income $ $214,500\mathrm{.}00$

Taxes $45,045\mathrm{.}00$

Net income $ $169,455\mathrm{.}00$

Dividends $ $30,000\mathrm{.}00$

Additions to

retained earnings $ $139,455\mathrm{.}00$

Balance Sheet

Assets Liabilities and Equity

Current assets $$240,000\mathrm{.}00$ Total debt $$880,000\mathrm{.}00$

Net fixed assets $$1,350,000\mathrm{.}00$ Owners' equity $$710,000\mathrm{.}00$

Total assets $$1,590,000\mathrm{.}00$ Total debt and equity $$1,590,000\mathrm{.}00$

Note: Beginning Fixed Assets $=$ $$1,125,000$

a$.(40$ Points$)$ Calculate the necessary ratios and parameters needed for financial planning in preparation for constrcuting the proforma balance sheet.

b$.(40$ Points$)$ Construct the proforma financial statements $($i$.$e$.,$ income statement and balance sheet$)$ using the parameters you calculated. Your proforma balance sheet should balance. What is the total debt necessary to balance the proforma balance sheet?