Chapter 15 - Answer

Solutions Manual

CHAPTER 15 FINANCIAL FORECASTING FOR STRATEGIC GROWTH SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions 1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 2. Accounts payable, accrued wages and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately. 3. False. At low growth rates, internal financing will take care of the firm’s needs. 4. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates that there is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable growth rate is certainly greater than 15%, because there is additional debt financing used in that case (assuming the firm is not 100% equityfinanced). As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets. II. Problems Problem 1 (Pro Forma Statements) 15-1

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Financial Forecasting for Strategic Growth

It is important to remember that equity will not increase by the same percentage as the other assets. If every other item on the income statement and balance sheet increases by 15 percent, the pro forma income statement and balance sheet will look like this: Pro forma Income Statement Sales Costs Net income

Pro forma Balance Sheet

₱26,450 Assets 19,205 ₱ 7,245 Total

₱18,170 Debt _______ Equity ₱18,170 Total

₱ 5,980 12,190 ₱18,170

In order for the balance sheet to balance, equity must be: Equity = Total liabilities and equity – Debt Equity = ₱18,170 – 5,980 = ₱12,190 Equity increased by: Equity increase = ₱12,190 – 10,600 = ₱1,590 Net income is ₱7,245 but equity only increased by ₱1,590; therefore, a dividend of ₱5,655 must have been paid. Dividends paid is the additional financing needed. Dividend = ₱7,245 – 1,590 = ₱5,655 Problem 2 (Calculating EFN) An increase of sales to ₱7,424 is an increase of: Sales increase = (₱7,424 – 6,300) / ₱6,300 = .18 or 18% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma Income Statement Sales Costs

Pro forma Balance Sheet

₱7,434 Assets 4,590 15-2

₱21,594 Debt _______ Equity

₱12,400 8,744

Financial Forecasting for Strategic Growth

Net income

₱2,844 Total

₱21,594 Total

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₱21,144

If no dividends are paid, the equity account will increase by the net income, so: Equity = ₱5,900 + 2,844 = ₱8,744 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = ₱21,594 – 21,144 = ₱450 Problem 3 (Calculating EFN) An increase of sales to ₱21,840 is an increase of: Sales increase = (₱21,840 – 19,500) / ₱19,500 = .12 or 12% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma Income Statement

Pro forma Balance Sheet

Sales

₱21,840 Assets

Costs EBIT

16,800 5,040 Total

Taxes (40%) Net income

₱109,76 Debt 0 ______ _ Equity ₱109,76 Total 0

₱52,500 79,208 ₱99,456

2,016 ₱ 3,024

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = (₱1,400 / ₱2,700) (₱3,024) = ₱1,568 The addition to retained earnings is: Addition to retained earnings = ₱3,024 – 1,568 = ₱1,456 And the new equity balance is: 15-3

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Financial Forecasting for Strategic Growth

Equity = ₱45,500 + 1,456 = ₱46,956 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = ₱109,760 – 99,456 = ₱10,304 Problem 4 (Sales and Growth) The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable growth rate, first we need to calculate the ROE, which is: ROE = NI / TE ROE = ₱8,910 / ₱56,000 = .1591 or 15.91% The plowback ratio, b, is one minus the payout ratio, so: b = 1 – .30 = .70 Now we can use the sustainable growth rate equation to get: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [.1591(.70)] / [1 – .1591(.70)] = .1253 or 12.53% So, the maximum peso increase in sales is: Maximum increase in sales = ₱42,000 (.1253) = ₱5,264.03 Problem 5 (Calculating Retained Earnings from Pro Forma Income) Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look like this: Jordan Corporation Pro Forma Income Statement ₱45,600.00 22,080.00

Sales Costs 15-4

Financial Forecasting for Strategic Growth

Taxable income Taxes (34%) Net income

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₱23,520.00 7,996.80 ₱ 15,523.20

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = (₱5,200/₱12,936) (₱15,523.20) = ₱6,240.00 And the addition to retained earnings will be: Addition to retained earnings = ₱15,523.20 – 6,240 = ₱9,283.20 Problem 6 (Applying Percentage of Sales) Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes payable, total current liabilities, long-term debt, and all equity accounts do not vary directly with sales. Jordan Corporation Balance Sheet (₱)

Assets Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment Total assets Liabilities and Owners’ equity Current liabilities Accounts payable Notes payable Total Long-term debt Owners’ equity Common stock and paid-in surplus Retained earnings 15-5

(%)

₱ 3,050 6,900 7,600 ₱17,550

8.03 18.16 20.00 46.18

₱34,500 ₱52,050

90.79 136.97

₱ 1,300 6,800 ₱ 8,100 ₱25,000

3.42 n/a n/a n/a

₱15,000 3,950

n/a n/a

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Financial Forecasting for Strategic Growth

₱18,950 ₱52,050

Total Total liabilities and Owners’ equity

n/a n/a

Problem 7 (External Financing Requirements) a., b., & c. Lewis Company Pro Forma Income Statement December 31, 2012 (Millions of Pesos)

Sales Operating costs EBIT Interest EBT Taxes (40%) Net income

2011 ₱8,000 7,450 ₱ 550 150 ₱ 400 160 ₱ 240

(1 + g) (1.2) (1.2)

Dividends: ₱1.04 x 150 = Addition to RE:

₱1.10 ₱ 156 x 150 ₱ 84

1st Pass 2012 ₱9,600 8,940 ₱ 660 150 ₱ 510 204 ₱ 306

AFN Effects

₱ 165 ₱ 141

+30*

2nd Pass 2012 ₱9,600 8,940 ₱ 660 180 ₱ 480 192 ₱ 288

+24**

₱ 189 ₱ 99

*∆ in interest expense = (₱51 + ₱248) x 0.10 = ₱30. **∆ in 2012 Dividends = ₱368/₱16.96 x ₱1.10 = ₱24. ∆ in addition to retained earnings = ₱99 − ₱141 = −₱42. Lewis Company Pro Forma Balance Sheet December 31, 2012 (Millions of Pesos)

Cash

2011 ₱ 80

(1 + g) (1.2)

Additions

Accounts 15-6

1st Pass 2012 ₱ 96

AFN Effects

2nd Pass 2012 ₱ 96

Financial Forecasting for Strategic Growth

receivable Inventory Total current assets Fixed assets Total assets Accounts payable Accruals Notes payable Total current liabilities Long-term debt Total debt Common stock Retained earnings Total liabilities and equity

240 720 ₱1,04 0 3,200 ₱4,24 0 ₱ 160 40 252

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(1.2) (1.2)

288 864

288 864 ₱1,248

(1.2)

₱1,24 8 3,840 ₱5,08 8 ₱ 192 48 252

₱ 192

(1.2) (1.2)

₱ 452 1,244 ₱1,69 6 1,605

₱ 492 1,244 ₱1,73 6 1,605

939

141*

₱4,24 0

1,080 ₱4,42 1 ₱ 667

AFN =

*See Income Statement, 1st pass. ** CA/CL = 2.3; D/A = 40%. Maximum total debt = 0.4 x ₱5,088 = ₱2,035. Maximum increase in debt = ₱2,035 − ₱1,736 = ₱299. Maximum current liabilities = ₱1,248/2.3 = ₱543. Increase in notes payable = ₱543 − ₱492 = ₱51. Increase in long-term debt = ₱299 − ₱51 = ₱248. Increase in common stock = ₱667 − ₱299 = ₱368. ***∆ in RE = ₱99 − ₱141 = −₱42. Problem 8 (Long-term financing needed)

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3,840 ₱5,088

48 303

+51**

₱543 +248**

1,492 ₱2,035

+368**

1,973

−42***

1,038 ₱5,046 ₱

42

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Financial Forecasting for Strategic Growth

a. Total liabilities and equity = Accounts payable + Long-term debt + Common stock + Retained earnings ₱1,200,000 = ₱375,000 + LTD + ₱425,000 + ₱295,000 Long-term debt (LTD) = ₱105,000 Total debt = Accounts payable + Long-term debt Total debt = ₱375,000 + ₱105,000 = ₱480,000 Alternatively; Total debt = Total liabilities and equity − Common stock − Retained earnings Total debt = ₱1,200,000 − ₱425,000 − ₱295,000 = ₱480,000 b. Assets/Sales (A*/S) = ₱1,200,000/₱2,500,000 = 48% Liabilities/Sales (L*/S) = ₱375,000/₱2,500,000 = 15% 2012 Sales = (1.25) (₱2,500,000) = ₱3,125,000 AFN = (A*/S) (∆S) − (L*/S) (∆S) − PS2 (1 − D) = (0.48) (₱625,000) – (0.15) (₱625,000) – (0.06) (₱3,125,000) (0.6) − ₱75,000 AFN = ₱300,000 − ₱93,750 − ₱112,500 − ₱75,000 = ₱18,750 Problem 9 (Additional Funds Needed) Cash Accounts receivable Inventory Net fixed assets Total assets

₱ 100 200 200 500 ₱1,000

x x x +

2 2 2 0.0

= = = =

₱ 200 400 400 500 ₱1,500

Accounts payable Notes payable Accruals Long-term debt Common stock Retained earnings

₱

x

2

=

x

2

=

+

40

=

₱ 100 150* 100 400 100 290

50 150 50 400 100 250

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Financial Forecasting for Strategic Growth

Total liabilities and equity

₱1,000

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₱1,140 ₱360

AFN = *₱150 + ₱360 = ₱510 Capacity sales = Current sales/0.5 = ₱1,000/0.5 = ₱2,000 Target FA/S ratio = ₱500/₱2,000 = 0.25

Target FA = 0.25 (₱2,000) = ₱500 = Required FA. Since the firm currently has ₱500 of FA, no new FA will be required. Addition to RE = P (S2) (1 – Payout ratio) = 0.05 (₱2,000) (0.4) = ₱40 Problem 10 (Additional Funds Needed) Percent of Sales Table Cash Accounts receivable Inventory Current assets (spontaneous)

5% Accounts payable 30 Accrued expenses 20 55% Current liabilities (spontaneous)

30.0% 2.5 32.5%

Sales = 20% (₱3,000,000) = ₱600,000 New Sales level = ₱3,000,000 + ₱600,000 = ₱3,600,000 New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D) NFR = 55% (₱600,000) – 32.5% (₱600,000) – 8% (₱3,600,000) (1 – 7) NFR = ₱330,000 – ₱195,000 – ₱86,400 = ₱48,600 Problem 11 (Percent-of-sales method) Sales = (10%) (₱100,000,000) = ₱10,000,000 New Sales level = ₱100,000,000 + ₱10,000,000 = ₱110,000,000 15-9

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Financial Forecasting for Strategic Growth

New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D) = (₱85,000,000/100) (₱10,000,000) – (₱25,000,000/100) (₱10,000,000) − .07 (₱110,000,000) (.60) NFR = ₱8,500,000 − ₱2,500,000 − ₱4,620,000 = ₱1,380,000 Problem 12 (Percent-of-sales method) a. Sales = (15%) (₱300,000,000) = ₱45,000,000 New Sales level = ₱300,000,000 + ₱45,000,000 = ₱345,000,000 New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D) = (₱240,000,000/₱300,000,000) (₱45,000,000) – (₱120,000,000/₱300,000,000) (₱45,000,000) − .08 (₱345,000,000) (1 − .25) NFR

= ₱36,000,000 − ₱18,000,000 − ₱20,700,000 = (₱2,700,000)

A negative figure for new funds required indicated that an excess of funds (₱2,700,000) is available for new investment. No external funds are needed. b. New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D) = ₱36,000,000 − ₱18,000,000 − .095 (₱345,000,000) (1 − .5) = ₱36,000,000 − ₱18,000,000 − ₱16,387,500 NFR

= ₱1,612,500 external funds required

The net profit margin increased slightly, from 8% to 9.5%, which decreases the need for external funding. The dividend payout ratio increased tremendously, however, from 25% to 50%, necessitating more external financing. The effect of the dividend policy change overpowered the effect of the net profit margin change. Problem 13 (External Funds Requirement) 15-10

Financial Forecasting for Strategic Growth

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a. Sales = (15%) (₱100,000,000) = ₱15,000,000 Spontaneous Assets = 5% + 15% + 20% + 40% = 80% Spontaneous Liabilities = 15% + 10% = 25% New Sales level = ₱100,000,000 + ₱15,000,000 = ₱115,000,000 New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D) NFR = 80% (₱600,000) – 25% (₱600,000) – 10% (₱115,000,000) (1 – .5) NFR = ₱12,000,000 – ₱3,750,000 – ₱5,750,000 = ₱2,500,000 b. If Mercury reduces the payout ratio, the company will retain more earnings and need less external funds. A slower growth rate means that less assets will have to be financed and in this case, less external funds would be needed. A declining profit margin will lower retained earnings and forced Mercury to seek more external funds.

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