business finance
QUESTION 1
(i) Eli Lilly is very excited because sales for his nursery and plant company are expected to double from $600,000 to $1,200,000 next year. Eli notes that net assets
(Assets — Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. Does his optimistic outlook for his cash position appear to be correct? Compute his likely cash balance or deficit for the end of the year. Start with beginning cash and subtract the asset buildup (equal to 50 percent of the sales increase) and add in profit.
(ii) In problem 1 if there had been no increase in sales and all other facts were the same, what would Eli’s ending cash balance be? What lesson do the examples in problems 1 and 2 illustrate?
(i) The calculation starts with the beginning cash which is subtracted the asset buildup and then added in profit. As to why subtract the asset buildup? This is because the calculation should be working with net assets (assets and liabilities), which is short for “assets not financed with debt”. Because any asset not financed with debt in reality must be funded either with fresh equity or with retained earnings, the total $300,000 increase in assets needs to be supported by an increase in debt (Jensson, 2006).
Beginning cash $120,000
Asset buildup (300,000) (50%* $1,200,000)
Profit 96,000 (8%* $1,200,000)
Ending cash ($84,000) Deficit
Therefore, his optimistic outlook for his cash position is wrong. Cash will be in a deficit.
(ii) In problem 1 if there had been no increase in sales and all other facts, the new calculation is shown below.
Beginning cash $120,000
Asset buildup (0)
Profit 48,000 (8%* $600,000)
Ending cash $168,000 Balance
Therefore, even though no increase in sales, Eli Lilly would end up with cash
(i) Eli Lilly is very excited because sales for his nursery and plant company are expected to double from $600,000 to $1,200,000 next year. Eli notes that net assets
(Assets — Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. Does his optimistic outlook for his cash position appear to be correct? Compute his likely cash balance or deficit for the end of the year. Start with beginning cash and subtract the asset buildup (equal to 50 percent of the sales increase) and add in profit.
(ii) In problem 1 if there had been no increase in sales and all other facts were the same, what would Eli’s ending cash balance be? What lesson do the examples in problems 1 and 2 illustrate?
(i) The calculation starts with the beginning cash which is subtracted the asset buildup and then added in profit. As to why subtract the asset buildup? This is because the calculation should be working with net assets (assets and liabilities), which is short for “assets not financed with debt”. Because any asset not financed with debt in reality must be funded either with fresh equity or with retained earnings, the total $300,000 increase in assets needs to be supported by an increase in debt (Jensson, 2006).
Beginning cash $120,000
Asset buildup (300,000) (50%* $1,200,000)
Profit 96,000 (8%* $1,200,000)
Ending cash ($84,000) Deficit
Therefore, his optimistic outlook for his cash position is wrong. Cash will be in a deficit.
(ii) In problem 1 if there had been no increase in sales and all other facts, the new calculation is shown below.
Beginning cash $120,000
Asset buildup (0)
Profit 48,000 (8%* $600,000)
Ending cash $168,000 Balance
Therefore, even though no increase in sales, Eli Lilly would end up with cash
References: Buzacott, J. A., & Zhang, R. Q. (2004). Inventory management with asset-based financing. Management Science, 50(9), 1274-1292. Dechow, P. M., Kothari, S. P., & L Watts, R. (1998). The relation between earnings and cash flows. Journal of Accounting and Economics, 25(2), 133-168. Jensson, P. (2006). Profitability Assessment Model. Reykjavík, Iceland.