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chap 4


Department
Finance
Course Code
FIN 300
Professor
Scott Anderson

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CHAPTER 4
LONG-TERM FINANCIAL PLANNING
AND GROWTH
Answers to Concepts Review and Critical Thinking Questions
1. The reason is that, ultimately, sales are the driving force behind a business. A firms assets, employees, and, in
fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put
differently, a firms future need for things like capital assets, employees, inventory, and financing are
determined by its future sales level.
2. Two assumptions of the sustainable growth formula are that the company does not want to sell new equity, and
that financial policy is fixed. If the company raises outside equity, or increases its debt-equity ratio it can grow
at a higher rate than the sustainable growth rate. Of course the company could also grow faster than its profit
margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover
increases.
3. 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% equity-financed). 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.
4. The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN indicates that
there is excess financing still available. If the firm is 100% equity financed, then the sustainable and internal
growth rates are equal and the internal growth rate would be greater than 20%. However, when the firm has
some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether
the internal growth rate would be greater than or less than 20%. If the retention ratio is increased, the firm will
have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio
constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the
retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change
in total assets.
5. Presumably not, but, of course, if the product had been much less popular, then a similar fate would have
awaited due to lack of sales.
6. Since customers did not pay until shipment, receivables rose. The firms NWC, but not its cash, increased. At
the same time, costs were rising faster than cash revenues, so operating cash flow declined. The firms capital
spending was also rising. Thus, all three components of cash flow from assets were negatively impacted.
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7. Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the extra demand
from the lower price.
8. Financing possibly could have been arranged if the company had taken quick enough action. Sometimes it
becomes apparent that help is needed only when it is too late, again emphasizing the need for planning.
9. All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom.
An inadequate cash resource is usually cited as the most common cause of small business failure.
10. Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via
new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may
be especially beneficial.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
1. 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 10 percent, the pro forma income statement
and balance sheet will look like this:
Pro forma income statement Pro forma balance sheet
Sales $ 17,600 Assets$ 9,790 Debt $ 5,610
Costs 13,750 Equity 4,180
Net income$ 3,850 Total$ 9,790 Total$ 9,790
In order for the balance sheet to balance, equity must be:
Equity = Total liabilities and equity – Debt
Equity = $9,790 – 5,610
Equity = $4,180
Equity increased by:
Equity increase = $4,180 – 3,800
Equity increase = $380
Net income is $3,850 but equity only increased by $380; therefore, a dividend of:
Dividend = $3,850 – 380
Dividend = $3,470
must have been paid. Dividends paid is the plug variable.
2. Here we are given the dividend amount, so dividends paid is not a plug variable. If the company pays out one-
half of its net income as dividends, the pro forma income statement and balance sheet will look like this:
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