Lahore School of Economics. Advance Corporate Finance. MBA II - Winter 2014. Dr. Sohail Zafar

Lahore School of Economics. Advance Corporate Finance. MBA II . Winter 2014. Dr.
Sohail Zafar
Lectures 9 & 10
Financial Planning Case Study . This is a case about a start-up trading business
You and your six cousins have planned to start a new business by subscribing each of you 100,000 shares of Rs 10
par value in a proposed new company thus each of you providing 1 million rupees as the seed money. You
estimate that monthly sales for the first three months would be rupees 100,000 , 120,000 and 150,000. To attract
customers you plan to offer liberal credit terms, so that 90% sales of a month would be collected next month
while, 10% would never be collected. Therefore you intend to record each months bad debt expense in that
months income statement as if the bad debt expense has been incurred. You have discovered since you have no
credit history, therefore suppliers of inventory would demand cash for your purchases of inventory. Your estimate
of inventory purchases per month is Rs 90,000 per month so that you slowly build up your stocks of inventory in
your shop rather than buying it in one go in the start of business; this is also important from the marketing view
point because designs/fashions/fads keep changing so fast that old stocks become obsolete very quickly thus over
stocking is risky.
You have negotiated for a 3,000 square feet shop in liberty market. PAGRI is 5 million rupees. It is a type of good
will money you have to pay to the present tenant or owner of the shop, hopefully when you leave this shop after a
few years you will receive Pagri from the next tenant of this shop. In well established markets such as Liberty
Market, Pagri is huge amount. Monthly rent of shop is Rs 10,000 and will be paid in advance for one year. Fixtures
including shelves, carpeting, AC, neon signs, etc would require Rs 600,000 and would be depreciated over five
years on straight line basis. In first month of operation you plan to spend 100,000 Rs on advertising and on
subsequent two months Rs 50,000 per month. You plan to act as manager and intend to hire 2 sales persons:
total monthly salaries of all three persons would be Rs 60,000. Electric, Phone and other bills are estimated to be
Rs 20,000 per month. Both salaries and utility bills of a month would be paid beginning of next month. You would
need a license from the government of Lahore City costing Rs 6,000 and you intend to amortize this on monthly
basis over one year.
Initial cost to set up the corporation including legal fees and SECP requirements are
estimated Rs 10,000 and you intend to amortize this organizational cost over 5 years by charging monthly
amortization expense in your income statement.
It is your estimate that gross profit margin on sales would be 60%. You plan to maintain minimum cash balance of
Rs 200,000 end of each month. Cash that is in excess of Rs 200,000 would be invested in a bank deposit account
to earn percent per month and interest would be received on the last day of the same month; and in the month
cash is short you plan to borrow from bank at 1% per month, and interest expense on loan would be paid monthly
at the end of the same month.
55
Lahore School of Economics. Advance Corporate Finance. MBA II . Winter 2014. Dr. Sohail Zafar
Required:
Please prepare monthly cash budget for three months and also the total for the three-month period.
Please prepare income statements for each month to show results of operations of each month as well as prepare
income statement for the three month period.
Please prepare balance sheets as of last day of each of the three month.
Cash Budget
Please note M stands for month
Cash Inflows
M1
M2
M3
TOTAL
Investment by owners
7,000,000
7,000,000
Collection of Sales
90,000
108,000
198,000
Total inflows (a)
7,000,000
90,000
108,000
7,198,000
Pagri
5,000,000
5,000,000
Purchases
90,000
90,000
90,000
270,000
Business License
6,000
6,000
Organizational Cost
10,000
10,000
Advance Rent
120,000
120,000
Fixture & Furniture
600,000
600,000
Advertising
100,000
50,000
50,000
200,000
Salaries
60,000
60,000
120,000
Phone/Utilities
20,000
20,000
40,000
Total Outflows (b)
5,926,000
220,000
220,000
6,366,000
Net Cash Flows (a b)
1,074,000
-130,000
-112,000
832,000
1,078,370
952,110
Cash Outflows
+Beginning Cash Balance
- Minimum Cash
-200,000
-200,000
-200,000
-200,000
Surplus/Shortage of Cash
874,000
748,370
640,110
632,000
% Interest Income
4,370
3,740
3,200
11,310
Cash after Interest income
878,370
752,110
643,310
643,310
Ending Cash Balance
1,078,370
952,110
843,310
843,311
56
Please note: Ending cash Balance = Cash After Interest income + Minimum Cash . Please also note that ending cash
balance of this month becomes beginning cash balance for the next month. Ending cash balance goes on the asset
side of balance sheet of each month. Ending cash balance at the end of M 3 and ending cash balance for the whole
three-month period must be same, in this case it is 843,311, because it is the same date when M3 ends as well as
the three- month period , that is Quarter 1,ends, so cash on that date must be the same amount.
Projected Income statements for each of the three months and for the whole three-month period
M1
M2
M3
TOTAL
Sales
100,000
120,000
150,000
370,000
CGS (40% of sales)
40,000
48,000
60,000
148,000
GP 60% of sales
60,000
72,000
90,000
222,000
Operating Expenses
Rent
10,000
10,000
10,000
30,000
Salaries
60,000
60,000
60,000
180,00
Advertising
100,000
50,000
50,000
200,000
Utilities
20,000
20,000
20,000
60,000
License amortization
500
500
500
1,500
Depreciation Expense fixture
10,000
10,000
10,000
30,000
Amortization Organization cost
166
166
166
500
12,000
15,000
37,000
Bad debt expense (10% of sales) 10,000

------------------------------------------- ------------
--------------
--------------
---------------
Total Operating Expenses
210,666
162,666
165,666
538,998
Operating Profits (EBIT)
-150,666
-90,666
-75,666
-317,000
+Interest Income
4,370
3,741
3,200
11,311
EBT
-146,296
-86,925
-72,466
-305,689
Corporate Income Tax
NI
-146,296
-86,925
-72,466
-305,689
===
========
=======
=======
=========
57
Note: To work out Retained Earnings (RE) balance that goes in the OE portion of balance sheet of each month
please use the following equation format of statement of changes in RE:
M1
M2
M3
Ending RE
= Beginning RE +
Ending RE
= 0
Ending RE
= -146,296
Ending RE
= -146, 296
Ending RE
=-233,221
Ending RE
= -233,221
Ending RE
=-305,687
NI
- cash dividends stock dividends (bonus shares)
+ -146,296
-0
-0
+-86,925
-0
-0
+-72,466
-0
-0
Please note: due to loss shown in each months income statement the negative balance of RE in the balance sheet
is rising at the end of each month; if there were profits in each month the RE balance would have been positive
and rising. In this case such negative balance of RE is termed Accumulated Losses.
Projected Balance Sheets on the last day of each month
M1
M2
M3
Cash
1,078,370
9,521,10
8,433,10
R/A (90% of sales)
90,000
108,000
135,000
Inventory
50,000
92,000
122,000
Fixtures
600,000
600,000
600,000
-Accumulated depreciation
(10,000)
(20,000)
(30,000)
Fixture (net)
590,000
580,000
570,000
Organizational cost
9,834
9,668
9,502 (Amortization 166Rs/month)
License fee
5,500
5,000
4,500 (Amortization 500 Rs/month)
Prepaid Rent
110,000
100,00
90,000
Pagri
5,000,000
5,000,000
5,000,000
Total Assets
6,933,704
6,846,778
6,774,312
58
Salaries Payable
60,000
60,000
60,000
Utilities Payable
20,000
20,000
20,000
TL
80,000
80,000
80,000
Paid up Share Capital
7,000,000
7,000,000
7,000,000
RE
-146,296
-233,221
-305,687
OE
6,853,704
6,766,779
6,694,313
TL+OE
6,933,704
6,846,779
6,774,313
Please note: the difference of 1 Rs in 2 sides of balance sheet is due to rounding of amortization of 166.66 to 166.
To estimate R/A ( accounts receivable) and inventory amounts that go in the balance sheets of each month, the
following analytical accounting equations were used to estimate ending balance of accounts receivables and
ending balance of inventory at the end of each month.
Beg R/A + Sales - Ending R/A - Bad Debt expense = Cash collected from customers
M1
+ 100
Ending R/A
- 10
90 = Ending R/A
M2
90
+ 120 Ending R/A - 12 = 90
108 = Ending R/A
M3
108
+ 150 Ending R/A - 15 = 108
135= Ending R/A
59
=0
Beginning inventory +Purchase of inventory -Ending inventory = CGS

M1
+ 90
- Ending inventory =40
50 = Ending inventory
M2
50
+ 90
- Ending inventory =48
140 - 48 = Ending inventory

92 =
M3
92
Ending inventory
+90
- Ending inventory = 60
182- 60 = Ending inventory

122 = Ending inventory
Please note that this planning exercise has certain important managerial lessons as well. For example you saw this
businesss operations did not do well and it has losses in all three months; but on the other hand its financial
health ( or financial position) in quite strong because its TL as compared to OE is very small, an TL are financing
only a small %age of TA, though over three months this %age is increasing yet it is less than 1% of TA that are
financed by TL . So due to poor profitability , the solvency is deteriorating. On the other hand , liquidity of this
business is quite high, its current ratio is more than 10 in each month . You also learnt that operating
performance is embodied in the income statement while financial health is embodied in the balance sheet. You
have learnt the linkages between cash budget, income statement, and balance sheet.
60

Lahore School of Economics. Advance Corporate Finance. MBA II - Winter 2014. Dr. Sohail Zafar

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Lahore School of Economics. Advance Corporate Finance. MBA II - Winter 2014. Dr. Sohail Zafar

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Total inflows (a)

Fixture & Furniture

Total Outflows (b)

Net Cash Flows (a b)

+Beginning Cash Balance

Cash after Interest income

Ending Cash Balance

CGS (40% of sales)

Depreciation Expense fixture

Amortization Organization cost

Bad debt expense (10% of sales) 10,000

Total Operating Expenses

Operating Profits (EBIT)

Corporate Income Tax

- cash dividends stock dividends (bonus shares)

R/A (90% of sales)

9,502 (Amortization 166Rs/month)

4,500 (Amortization 500 Rs/month)

Paid up Share Capital

+ 120 Ending R/A - 12 = 90

108 = Ending R/A

+ 150 Ending R/A - 15 = 108

135= Ending R/A

Beginning inventory +Purchase of inventory -Ending inventory = CGS

- Ending inventory =40

- Ending inventory =48

140 - 48 = Ending inventory

182- 60 = Ending inventory

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