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Chapter 3: Financial Planning and Growth

Questions and Problems:

3.1 An increase of sales to $42,300 is an increase of:

Sales increase = ($42,300 – $37,300) / $37,300

Sales increase = 0.1340, or 13.40%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma income statement Pro forma Statement of Financial Position

Sales $42,300.00 Assets $144,024.13 Debt  $30,500.00

Costs 29,258.45 Equity 102,272.31

EBIT $13,041.55 Total $144,024.13 Total $132,772.31

Taxes (34%) 4,434.13

Net income $8,607.43

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = ($2,500 / $7,590)($8,607.43)

Dividends = $2,835.12

The addition to retained earnings is:

Addition to retained earnings = $8,607.43 – $2,835.12

Addition to retained earnings = $5,772.31

And the new equity balance is:

Equity = $96,500 + $5,772.31

Equity = $102,272.31

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $144,024.13 – $132,772.31

EFN = $11,251.82

3.2 The maximum percentage sales increase without issuing new equity is the sustainable growth rate.

To calculate the sustainable growth rate, we first need to calculate the ROE, which is:

ROE = NI / TE

ROE = $15,312 / $81,000

ROE = 0.1890

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – 0.30

b = 0.70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.1890(0.70)] / [1 – 0.1890(0.70)]

Sustainable growth rate = 0.1525 or 15.25%

So, the maximum dollar increase in sales is:

Maximum increase in sales = $67,000(0.1525)

Maximum increase in sales = $10,217.93

3.3 We need to calculate the retention ratio to calculate the sustainable growth rate. The retention ratio is:

b = 1 – 0.10

b = 0.90

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.15(0.90)] / [1 – 0.15(0.90)]

Sustainable growth rate = 0.1561 or 15.61%

3.4 We must first calculate the ROE using the Du Pont ratio to calculate the sustainable growth rate. The ROE is:

ROE = (PM)(TAT)(EM)

ROE = (0.081)(1.90)(1.25)

ROE = 0.1924 or 19.24%

The plowback ratio is one minus the dividend payout ratio, so:

b = 1 – 0.30

b = 0.70

Now, we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.1924(0.70)] / [1 – 0.1924(0.70)]

Sustainable growth rate = 0.1556 or 15.56%

3.5 An increase of sales to $6,669 is an increase of:

Sales increase = ($6,669 – $5,700) / $5,700

Sales increase = 0.17 or 17%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma income statement Pro forma Statement of Financial Position

Sales $ 6,669 Assets          $16,497  Debt    $6,300

Costs 4,469 Equity 10,000

Net income $ 2,200 Total $16,497 Total $16,300

If no dividends are paid, the equity account will increase by the net income, so:

Equity = $7,800 + $2,200

Equity = $10,000

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $16,497 – $16,300 = $197

3.6 a. First, we need to calculate the current sales and change in sales. The current sales are next year’s sales divided by one plus the growth rate, so:

Current sales = Next year’s sales / (1 + g)

Current sales = $420,000,000 / (1 + 0.10)

Current sales = $381,818,182

And the change in sales is:

Change in sales = $420,000,000 – $381,818,182

Change in sales = $38,181,818

We can now complete the current Statement of Financial Position. The current assets, fixed assets, and short-term debt are calculated as a percentage of current sales. The long-term debt and par value of stock are given. The plug variable is the additions to retained earnings. So:

b. We can use the equation from the text to answer this question. The assets/sales and debt/sales are the percentages given in the problem, so:

EFN = × ΔSales – × ΔSales – (PM × Projected sales) × (1 – d)

EFN = (0.20 + 0.75) × $38,181,818 – (0.15 × $38,181,818) – [(0.09 × $420,000,000) × (1 – 0.30)]

EFN = $4,085,454

c. The current assets, fixed assets, and short-term debt will all increase at the same percentage as sales. The long-term debt and common stock will remain constant. The accumulated retained earnings will increase by the addition to retained earnings for the year. We can calculate the addition to retained earnings for the year as:

Net income = Profit margin × Sales

Net income = 0.09($420,000,000)

Net income = $37,800,000

The addition to retained earnings for the year will be the net income times one minus the dividend payout ratio, which is:

Addition to retained earnings = Net income (1 – d)

Addition to retained earnings = $37,800,000 (1 – 0.30)

Addition to retained earnings = $26,460,000

So, the new accumulated retained earnings will be:

Accumulated retained earnings = $137,454,546 + $26,460,000

Accumulated retained earnings = $163,914,546

The pro forma Statement of Financial Position will be:

The EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $399,000,000 – $394,914,546

EFN = $4,085,454

3.7 a. The sustainable growth is:

Sustainable growth rate =

where:

b = Retention ratio = 1 – Payout ratio = 0.60

So:

Sustainable growth rate =

Sustainable growth rate = 0.0853 or 8.530%

b. It is possible for the sustainable growth rate and the actual growth rate to differ. If any one of the actual parameters in the sustainable growth rate equation differs from that used to compute the sustainable growth rate, the actual growth rate will differ from the sustainable growth rate. Since the sustainable growth rate includes ROE in the calculation, this also implies that changes in the profit margin, total asset turnover, or equity multiplier will affect the sustainable growth rate.

c. The company can increase its sustainable growth rate by doing any of the following:

- Sell new shares of stock.

- Increase its reliance on debt.

- Increase the profit margin, most likely by better controlling costs.

- Decrease its total assets/sales ratio; in other words, utilize its assets more efficiently.

- Reduce the dividend payout ratio.

3.8 a. The equation for external funds needed is:

EFN = × ΔSales – × ΔSales – (PM × Projected sales) × (1 – d)

where:

Assets/Sales = $24,800,000/$30,400,000 = 0.8158

ΔSales = Current sales × Sales growth rate = $30,400,000(0.20) = $6,080,000

Debt/Sales = $6,400,000/$30,400,000 = 0.2105

PM = Net income/Sales = $2,392,000/$30,400,000 = 0.0787

Projected sales = Current sales × (1 + Sales growth rate) = $30,400,000(1 + 0.20) = $36,480,000

d = Dividends/Net income = $956,800/$2,392,000 = 0.40

so:

EFN = (0.8157 × $6,080,000) – (0.2105 × $6,080,000) – (0.0787 × $36,480,000) × (1 – 0.40)

EFN = $1,957,760

b. The current assets, fixed assets, and short-term debt will all increase at the same percentage as sales. The long-term debt and common stock will remain constant. The accumulated retained earnings will increase by the addition to retained earnings for the year. We can calculate the addition to retained earnings for the year as:

Net income = Profit margin × Sales

Net income = 0.0787($36,480,000)

Net income = $2,870,400

The addition to retained earnings for the year will be the net income times one minus the dividend payout ratio, which is:

Addition to retained earnings = Net income(1 – d)

Addition to retained earnings = $2,870,400(1 – 0.40)

Addition to retained earnings = $1,722,240

So, the new accumulated retained earnings will be:

Accumulated retained earnings = $10,400,000 + $1,722,240

Accumulated retained earnings = $12,122,240

The pro forma Statement of Financial Position will be:

	Assets		Liabilities and equity
	Current assets	$8,640,000	Short-term debt	$7,680,000
			Long-term debt	$4,800,000
	Fixed assets	$21,120,000	Common stock	$3,200,000
			Accumulated retained earnings	12,122,240
			Total equity	$15,322,240
	Total assets	$29,760,000	Total liabilities and equity	$27,802,240

The EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $29,760,000 – $27,802,240

EFN = $1,957,760

c. The sustainable growth is:

Sustainable growth rate =

where:

ROE = Net income/Total equity = $2,392,000/$13,600,000 = 0.1759

b = Retention ratio = Addition to Retained earnings/Net income = $1,435,200/$2,392,000 = 0.60

So:

Sustainable growth rate =

Sustainable growth rate = 0.1180 or 11.80%

d. The company cannot just cut its dividends to achieve the forecast growth rate. As shown below, even with a zero dividend policy, the EFN will still be $809,600.

	Assets		Liabilities and equity
	Current assets	$8,640,000	Short-term debt	$7,680,000
			Long-term debt	$4,800,000
	Fixed assets	$21,120,000	Common stock	$3,200,000
			Accumulated retained earnings	13,270,400
			Total equity	$16,470,400
	Total assets	$29,760,000	Total liabilities and equity	$28,950,400

The EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $29,760,000 – $28,950,400

EFN = $809,600

The company does have several alternatives. It can increase its asset utilization (sales to assets) and/or its profit margin. The company could also increase the debt in its capital structure. Any of these actions will increase ROE.

3.9 Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look like this:

MOOSE TOURS INC.

Pro Forma Income Statement

Sales   $1,114,800

Costs 867,600

Other expenses 22,800

EBIT $224,400

Interest 14,000

Taxable income $210,400

Taxes(35%) 73,640

Net income $136,760

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = ($33,735/$112,450)($136,760)

Dividends = $41,028

And the addition to retained earnings will be:

Addition to retained earnings = $136,760 – $41,028

Addition to retained earnings = $95,732

The new retained earnings on the pro forma Statement of Financial Position will be:

New retained earnings = $182,900 + $95,732

New retained earnings = $278,632

The pro forma Statement of Financial Position will look like this:

MOOSE TOURS INC.

Pro Forma Statement of Financial Position

Assets Liabilities and Shareholders’ Equity

Current assets Current liabilities

Cash $30,360 Accounts payable $81,600

Accounts receivable 48,840 Notes payable 17,000

Inventory 104,280 Total $98,600

Total $183,480 Long-term debt $158,000

Fixed assets

Net plant and Owners’ equity

equipment $495,600 Common stock and

paid-in surplus $140,000

Retained earnings 278,632

Total $418,632

Total liabilities and Shareholders’

Total assets $ 679,080 equity $ 675,232

So the EFN is:

EFN = Total assets – Total liabilities and Shareholders’ equity

EFN = $679,080 – $675,232

EFN = $3,848

3.10 The D/E ratio of the company is:

D/E = ($85,000 + $158,000) / $322,900

D/E = 0.7526

So the new total debt amount will be:

New total debt = 0.7526($418,632)

New total debt = $315,044

This is the new total debt for the company. Given that our calculation for EFN is the amount that must be raised externally and does not increase spontaneously with sales, we need to subtract the spontaneous increase in accounts payable. The new level of accounts payable will be, which is the current accounts payable times the sales growth, or:

Spontaneous increase in accounts payable = $68,000(0.20)

Spontaneous increase in accounts payable = $13,600

This means that $13,600 of the new total debt is not raised externally. So, the debt raised externally, which will be the EFN is:

EFN = New total debt – (Beginning LTD + Beginning CL + Spontaneous increase in AP)

EFN = $315,044 – ($158,000 + 85,000 + 13,600) = $58,444

The pro forma Statement of Financial Position with the new long-term debt will be:

MOOSE TOURS INC.

Pro Forma Statement of Financial Position

Assets Liabilities and Shareholders’Equity

Current assets Current liabilities

Cash $30,360 Accounts payable $81,600

Accounts receivable 48,840 Notes payable 17,000

Inventory 104,280 Total $98,600

Total $183,480 Long-term debt $216,444

Fixed assets

Net plant and Owners’ equity

equipment $495,600 Common stock and

paid-in surplus $140,000

Retained earnings 278,632

Total $418,632

Total liabilities and Shareholders’

Total assets $ 679,080 equity $ 733,676

The funds raised by the debt issue can be put into an excess cash account to make the Statement of Financial Position balance. The excess debt will be: