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Department
Finance
Course
FIN 300
Professor
Scott Anderson
Semester
Summer

Description
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. www.notesolution.com 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: www.notesolution.com www.notesolution.com Pro forma income statement Pro forma balance sheet Sales $ 17,600 Assets $ 9,790 Debt $ 5,100 Costs 13,750 Equity 5,725 Net income $ 3,850 Total $ 9,790 Total $ 10,825 Dividends $ 1,925 Add. to RE 1,925 Note that the balance sheet does not balance. This is due to EFN. The EFN for this company is: EFN = Total assets Total liabilities and equity EFN = $9,790 10,825 EFN = $1,035 3. An increase of sales to $5,192 is an increase of: Sales increase = ($5,192 4,400) / $4,400 Sales increase = .18 or 18% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma income statement Pro forma balance sheet Sales $ 5,192 Assets $ 15,812 Debt $ 9,100 Costs 3,168 Equity 6,324 Net income $ 2,024 Total $ 15,812 Total $ 15,424 If no dividends are paid, the equity account will increase by the net income, so: Equity = $4,300 + 2,024 Equity = $6,324 So the EFN is: EFN = Total assets Total liabilities and equity EFN = $15,812 15,424 = $388 4. An increase of sales to $23,040 is an increase of: Sales increase = ($23,040 19,200) / $19,200 Sales increase = .20 or 20% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma income statement Pro forma balance sheet Sales $ 23,040.00 Assets $ 111,600 Debt $ 20,400.00 Costs 18,660.00 Equity 74,334.48 EBIT 4,380.00 Total $ 111,600 Total $ 94,734.48 Taxes(34%) 1,489.20 Net income $ 2,890.80 The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: www.notesolution.com
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