Water Play, Inc.

Part 2—Shark Scout Vehicle

The corporate home office has provided the new subsidiary with $25 million cash
to begin operations. The company sells to their dealers on credit. Bad debts are expected
to occur and are projected to be .5% of sales revenue annually. Based on prior experience
with these targeted customers, accounts receivable collection is expected to be 67% in the
quarter of sale and the remainder in the following quarter.

All the inventory parts are purchased from vendors on credit. Ending raw
material inventory is planned to be 10% of the next quarter’s production needs. All other
cash expenditures/expenses are paid when incurred (since any accruals are minimal). The
company expects to pay 63% of any inventory purchased on account in the quarter of
purchase and 37% in the following quarter. Beginning raw material inventory is planned
at 10% of the first quarter’s production needs and its cost value appears on the beginning
balance sheet.

Finished goods inventory is planned at 10% of sales units for the next quarter. Even
though full-scale operations have not begun, the engineers and some newly hired laborers
have already constructed 1,800 units, which constitutes beginning finished goods
inventory under constant demand. Again note beginning finished goods inventory is
different under seasonal demand and is equal to 1,500 units because the forecast is to sell
15,000 units in quarter one. The cost of inventory has been absorbed by the parent
company and along with other assets, constitutes their “investment” in the subsidiary.
Work in process inventory will be minimal at the end of any quarter and for the year;
therefore, they will be ignored. Two different beginning balance sheets have been
provided under a constant demand pattern and then the seasonal demand pattern. The
only difference in the two beginning balance sheets is the raw material and finished
goods inventory figures in the asset section and to “balance” the balance sheet, the
contributed capital has been adjusted on the two balance sheets.

The corporation has borrowed $150 million from a bank to finance the acquisition
of the building, equipment, furniture and for the building’s renovations, which along with
the issuance of stock to the parent company, represents the financing sources of the assets
prior to the first year’s operations. The interest rate is 10% per year and the principal and
final interest payment will be due in eight years. Interest will be paid quarterly on this
long-term note in the cash budget. The company also negotiated a $100 million line of
credit at the bank which will also incur a 10% annual interest rate. This credit line is to
be used for financing operations but must be paid off at the end of the year; interest on
any short-term borrowing will be repaid at the end of quarter four along with the
principal borrowed on any needed loan. If borrowing is necessary on the line of credit,
the exact amount borrowed will cover any deficit if there is one, quarterly interest on the
long-term note and an amount to bring the ending balance up to $25 million which Water
Play desires to end each quarter with as the desired minimum balance. If the line of
credit is used, borrowing will occur at the beginning of the quarter in which the cash
balance will drop below the minimum required cash balance and the short-term
borrowing’s principal and interest will be paid off in full at the end of the year (quarter
four). The corporation requires a minimum cash balance of $25 million at the end of any
quarter.

The parent company has been issued 3 million shares of $1 par value common
stock in Water Play, Inc., which is a solely owned subsidiary of the parent. The
accountants have prepared a beginning balance sheet showing the financial position and
investment by the parent corporation.

1. The company is creating two sets of budgets under constant demand and seasonal
demand. Prepare the constant demand budget schedules culminating in the cash
budget, income statement and balance sheet. Expected sales under constant
demand are 18,000 per quarter for a total of 72,000 units for the year. Assume the
same quarterly and annual sales pattern to occur for year two. The information to
prepare the sales budget with the collections schedule, production budget, direct
materials budget with the disbursements schedule, direct labor budget,
manufacturing overhead budget, finished goods budget, and the selling and general
administrative expense budget are found in appendix A-1 through A-6 and
appendix B-1 the beginning balance sheet. The information from these schedules
and the appendices are used to prepare the cash budget by quarter and for the year
and then the income statement and balance sheet at the year’s end (not by quarter).

Briefly, discuss the key numbers/results from the constant demand budget
schedules, cash budget, income statement and balance sheet.

2. Recalculate all the budget schedules and then the cash budget, income statement
and the balance sheet based on expected unit sales of 15,000 in quarter one, 25,000
in quarter two, 20,000 in quarter three, and finally 12,000 in quarter four. Demand
is still expected to be 72,000 units for the year under a seasonal sales pattern.
Assume the same quarterly and annual sales pattern to occur for year two. The
beginning balance sheet under seasonal demand is appendix C-1.

Compare the constant demand to the seasonal demand budget. What differences
occur in the budget schedules and the cash budget, the income statement and the
balance sheet on a quarterly and an annual basis? Identify what caused these
differences.