On the Self-test: Corporate Finance: An analyst is constructing pro forma financial statements for Liden Plastics Corp that are based on an expected 8% increase in sales next year. His first iteration results in a financial surplus of $2.2million. Which of the following assumptions would result in no financial surplus or deficiency in the next iteration of the pro forma statements? A) The surplus will be used to decrease Liden’s outstanding long-term debt B) Liden will use the surplus to repurchase its common stock C) The surplus will be used to repurchase Liden’s common shares and reture long-term debt in amounts that preserve Liden’s existing capital structure — I answered (A), the correct answer is (B) In a similar case in SS11 reading #47 (pgs 80-81), it shows an example of an assumption made to reconcile a surplus in the pro forma statements by decreasing long-term debt. However, it states that successive iterations will result in a zero surplus. So, I guess the repurchasing of stock will fix the entire surplus by the next iteration…whereas using the surplus to decrease debt requires several iterations? I don’t fully understand Schweser’s explanation either. Also, I don’t think the SchweserNotes covered using a surplus to repurchase stock. Guess its a matter of doing EVERY question possible.
You are right that arriving at a balanced financing would require several iterations. This is because any reduction of outstanding debt decreases the next year’s interest expense and thus increases the tax expense. Consequently also the net income and equity will change (both should rise). Hence you will still have some, even though a lower, financing surplus. On the other hand, if you repurchase shares (=use the surplus to build up equity), there will be no tax consequences and the financing surplus will be entirely used up for the share repurchase.