Question 2.5: Santos Engineering Ltd started operations on 1 January Year ...
Santos Engineering Ltd started operations on 1 January Year 1 and has produced the following forecasts for annual sales revenue:
| Year to 31 December | Year 1 | Year 2 | Year 3 | Year 4 |
| Forecast sales revenue (£) | 500,000 | 550,000 | 640,000 | 720,000 |
The following additional information has been provided:
- The operating profit of the business is expected to be 20 per cent of the sales revenue throughout the four-year period.
- The company has issued £400,000 5 per cent loan notes, which are redeemable at the end of Year 4.
- The tax rate is expected to be 25 per cent throughout the four-year period. Tax is paid in the year following the year in which the relevant profits were made.
- An initial investment in working capital of £50,000 is required. Thereafter, investment in working capital is expected to represent 10 per cent of sales revenue for the relevant year.
- Depreciation of £40,000 per year must be charged for the non-current assets currently held.
- Land costing £490,000 will be acquired during Year 2. This will not be depreciated as it has an infinite life.
- Dividends of £30,000 per year will be announced for Year 1. Thereafter, dividends will rise by £6,000 each year. Dividends are paid in the year following the period to which they relate.
- The business has a current cash balance of £85,000.
We shall now prepare projected cash flow statements showing the financing requirements of the business for each of the next four years. The starting point is to calculate the projected operating profit for the period and then to make the depreciation and the working capital adjustments as described earlier. This will provide us with a figure of operating cash flows. We then simply adjust for the interest, tax and dividends to deduce the net cash flows from operations each year.
The financing requirements for Santos Engineering Ltd are calculated as follows:
| Projected cash flow statements | ||||
| Year 1 | Year 2 | Year 3 | Year 4 | |
| £ | £ | £ | £ | |
| Sales revenue | \underline{500,000} | \underline{560,000} | \underline{640,000} | \underline{700,000} |
| Operating profit (20%) | 100,000 | 112,000 | 128,000 | 140,000 |
| Depreciation | 40,000 | 40,000 | 40,000 | 40,000 |
| Working capital* | \underline{(50,000)} | \underline{(6,000)} | \underline{(8,000)} | \underline{(6,000)} |
| Operating cash flows | 90,000 | 146,000 | 160,000 | 174,000 |
| Interest | (20,000) | (20,000) | (20,000) | (20,000) |
| Tax** | (20,000) | (23,000) | (27,000) | |
| Dividends | (30,000) | (36,000) | (42,000) | |
| Non-current assets | (490,000) | |||
| Loan repayment | ______ | ______ | ______ | \underline{(400,000)} |
| Net cash flows from operations | 70,000 | (414,000) | 81,000 | (315,000) |
| Opening balance | \underline{85,000} | \underline{155,000} | \underline{(259,000)} | \underline{(178,000)} |
| Closing balance | \underline{155,000} | \underline{(259,000)} | \underline{(178,000)} | \underline{(493,000)} |
* The initial investment in working capital will be charged in the first year. Thereafter only increases (or decreases) in the level of working capital will be shown as an adjustment.
** The tax charge for each year is shown below.
| Year 1 | Year 2 | Year 3 | Year 4 | |
| £ | £ | £ | £ | |
| Operating profit (as above) | 100,000 | 112,000 | 128,000 | 140,000 |
| Interest | \underline{(20,000)} | \underline{(20,000)} | \underline{(20,000)} | \underline{(20,000)} |
| Profit before tax | 80,000 | 92,000 | 108,000 | 120,000 |
| Tax (25%) | \underline{(20,000)} | \underline{(23,000)} | \underline{(27,000) } | \underline{(30,000)} |
| Profit after tax | \underline{60,000} | \underline{69,000} | \underline{81,000} | \underline{90,000} |
Note: Tax will be paid in the year after the relevant profit is made.