Question

1. A’s sales are expected to increase by 15% from $8 million in 2016 to $9.2 million in 2017. A’s assets total $5 million at the end of 2016. A is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2016 current liabilities were $1.4 million, consisting of $450,000 of accounts payable, $500,000 of notes payable and $450,000 of accruals. The after-tax profit margin is forecasted to be 6%, and the forecasted payout ratio is 40%.

1. Use the AFN equation to forecast A’s additional funds needed for the coming year.
2. Now suppose that A’s 2016 assets had been $7 million. Calculate AFN and explain why the AFN is different from part a
3. Now assume that company uses $5 million in assets as before, but now assume that the company has a dividend payout of 25%. Calculate AFN and explain why the AFN is different from part a.
4. Assume we are back as the original scenario of $5 million in assets and that the payout ratio is 40%. Using the Self-Supporting Growth Rate equation. How large a percentage increase in sales can A achieve without having to raise funds externally? What is the total dollar amount of sales that A can sustain without having to raise any funds externally?

Answer 1

AFN EQUATION : $A_{0}*{\bigtriangleup S/}{{_{S_{0}}}}-L_{0}*{\bigtriangleup S/}{{_{S_{0}}}}-S_{1}*Profit Margin*b$

A₀ = Assets ( Current Level)

${\bigtriangleup S/}{{_{S_{0}}}}$ = Percentage change in sales

L₀ = Liabilities (Current Level)

S₁= After Growth Sales

b= Retention ratio =1- Payout

a) Acc to the AFN equation written above,

Additional funds needed : 5 * 1.2/8-1.4 * 1.2/8-9.2 * .06 * .60

=.75-.21-.3312

=$ 0.2088 Million

b) If the Assets in 2016 had been $7M instead of $6M, the AFN would turn out to be

7 * 1.2/8-1.4 * 1.2/8 - 9.2 * .06 * .60

=1.05-.21-.3312

=$ .5088 M

We can see that with the increase in assets of the current period in the equation the Additional Funds Needed also increases to finance the increase in assets for increase in sales.

c) Now there is a change in Payout ratio which will eventually change the retention ratio.

(New ) b= 1-.25 = .75

by putting the same in AFN equation, we get

= .75 - .21 - .414

= $0.126 M

We see that the AFN decreases when the payout percentage decreases as there will be more funds available with the company when it will spend less on dividends and more on investing funds by retaining the profits.

d) Sustainable Growth = ROE * b

ROE( Return on equity ) = Net Income/ Shareholders equity

b = retention ratio

Shareholders equity = Total Assets - Liabilities

= 5 - 1.4

= $3.6 M

Net Income    = Income after all expenses and taxes but before distribution of dividend

= Sales * Profit margin after tax = 8*.06 = $.48 M

ROE= .48/3.6

=0.1333

Sustainable growth = 0.1333 * .60

  = .07998 = 7.998%

The maximum amount of sales that A can sustain without having to raise external finances or debts is

8 + 7.998% of 8

= $8.64 M