Chapter 16, Problem 13P

ADDITIONAL FUNDS NEEDED Morrissey Technologies Inc.’s 2016 financial statements are shown here.

Morrissey Technologies Inc.: Balance Sheet as of December 31, 2016

Morrissey Technologies Inc.: Income Statement for December 31, 2016

Sales	$3,600,000
Operating costs including depredation	3,279,720
EBIT	$ 320,280
Interest	20,280
EBT	$ 300,000
Taxes (40%)	120,000
Net Income	$ 180,000
Per Share Data:
Common stock price	$45.00
Earnings per share (EPS)	$ 1.80
Dividends per share (DPS)	$ 1.08

Suppose that in 2017, sales increase by 10% over 2016 sales. The firm currently has 100,000 shares outstanding. It expects to maintain its 2016 dividend payout ratio and believes that its assets should grow at the same rate as sales. The firm has no excess capacity. However, the firm would like to reduce its operating costs/sales ratio to 87.5% and increase its total liabilities-to-assets ratio to 30%. (It believes its liabilities-to-assets ratio currently is too low relative to the industry average.) The firm will raise 30% of the 2017 forecasted interest- bearing debt as notes payable, and it will issue long-term bonds for the remainder. The firm forecasts that its before-tax cost of debt (which includes both short- and long-term debt) is 12.5%. Assume that any common stock issuances or repurchases can be made at the firm’s current stock price of $45.

1. a. Construct the forecasted financial statements assuming that these changes are made. What are the firm’s forecasted notes payable and long-term debt balances? What is the forecasted addition to retained earnings?
2. b. If the profit margin remains at 5% and the dividend payout ratio remains at 60%, at what growth rate in sales will the additional financing requirements be exactly zero? In other words, what is the firm’s sustainable growth rate? (Hint: Set AFN equal to zero and solve for g.)

Summary Introduction

To construct: The forecasted financial statements for the year 2017 and to calculate the firm’s forecasted notes payable and long-term debts balance and forecasted addition to retained earnings

Introduction:

Financial Statements:

Financial statements are the statements, which tell about the financial activities of the company. A financial statement of a company includes its income statement, balance sheet, and cash flows statement.

Income Statement:

Income statement is a business’s financial statement, which tells the financial performance of a company in an accounting period. It shows the income generated by a company and expenses incurred by a company through its operations.

Balance Sheet:

Balance sheet is the summarize statement of total assets and total liabilities of a company in an accounting period. It is one of the financial statements.

Additional Fund Needed:

Additional fund needed is also known as external financing needed. It is the state in which a company needed finance to increase its operation. Additional fund needed is a method in which a company raises the funds through external resources to increase its assets, which would increase the sales revenue of the firm.

But according to additional fund needed method, a company do not change its financial ratio. Liabilities and retained earnings spontaneously increase with the increase in sales and assets.

Explanation of Solution

Company M
Income Statement
For the year ended December 31,2017
Particulars	Amount ($)
Sales	3,960,000
Less:-Operating costs including depreciation	3,465,000
EBIT	495,000
Less:-Interest	111,375
EBT	383,625
Less:-Taxes	153,450
Net income	230,175
Per Share Data:
Common stock price	45
Earnings per share (EPS)	2.30
Dividends per share (DPS)	1.38

Table (1)

Company M
Balance Sheet
For the year ended December 31, 2017
Assets	Amount ($)	Amount ($)
Current assets:
Cash	198,000
Accounts receivable	396,000
Inventories	792,000
Total current assets		1,386,000
Fixed assets		1,584,000
Total Assets		2,970,000
Liabilities and Owners' Equity
Current Liabilities:
Notes payable	728,000
Total current Liabilities		728,000
Long-term debt		163,000
Total Liabilities		891,000
Owners' Equity:
Common stock	1,782,930
Retained Earnings	296,070
Total Stockholders' Equity		2,079,000
Total Liabilities and Owners' Equity		2,970,000

Calculation of forecasted notes payable for 2017,

Given,

Notes payable for 2016 are $56,000.

Company will raise notes payable by 30%.

Formula to calculate the forecasted notes payable for 2017,

$\text{Forecasted}\text{notes}\text{payable}\text{for}2017=\left(\begin{array}{l}\text{Notes}\text{payable}\text{for}2016\\ +\text{Increment}\text{in}\text{notes}\text{payable}\end{array}\right)$

Substitute $560,000 for notes payable for 2016 and 30% for increment in notes payable.

$\begin{array}{c}\text{Forecasted}\text{notes}\text{payable}\text{for}2017=\$560,000+\left(\$560,000\times 30\%\right)\\ =\$560,000+\$168,000\\ =\$728,000\end{array}$

Calculation of forecasted long term debts for 2017,

Given,

Liabilities (excluding retained earnings and common stock) for 2017 are $891,000 (working notes).

Notes payable for 2017 are $728,000.

Formula to calculate long term debts for 2017,

$\text{Long}\text{term}\text{debts}=\left[\begin{array}{l}\text{Liabilities}\left(\text{excluding}\text{retained}\text{earnings}\text{and}\text{common}\text{stock}\right)\\ -\text{Notes}\text{payable}\end{array}\right]$

Substitute $891,000 for liabilities (excluding retained earnings and common stock) and $728,000 for notes payable.

$\begin{array}{c}\text{Long}\text{term}\text{debts}=\$891,000-\$728,000\\ =\$163,000\end{array}$

Calculation of addition to retained earnings for the year 2017

Given,

Dividend paid for the year ended 2017 is $138,105.

Net income for the year ended is $230,175.

Formula to calculate addition to retained earnings,

$\text{Addition}\text{to}\text{retained}\text{earnings}=\text{Net}\text{income}-\text{Dividend}\text{paid}$

Substitute $230,175 for net income and $138,105 for dividend paid.

$\begin{array}{c}\text{Addition}\text{to}\text{retained}\text{earnings}=\$230,175-\$138,105\\ =\$92,070\end{array}$

Working notes:

Calculation of estimated sales for the year 2017

Given,

Sales for the year 2016 are $3,600,000.

Increment in sales is 10%.

Calculation of estimated sales for 2017,

$\begin{array}{c}\text{Estimated}\text{sales}\text{for}2017=\text{Sales}\text{for}2016+\text{Increment}\text{in}\text{sales}\\ =\$3,600,000+\left(\$3,600,000\times 10\%\right)\\ =\$3,600,000+\$360,000\\ =\$3,960,000\end{array}$

Calculation of estimated operating costs including depreciation for the year 2017

Given,

The firm would like to reduce its operating cost/sales ratio to 87.5%.

Sales of the year 2017 are $3,960,000.

Calculation of operating costs including depreciation,

$\begin{array}{c}\text{Operating}\text{costs}\text{including}\text{depreciation}=\text{Sales}\times 87.5\%\\ =\$3,960,000\times 87.5\%\\ =\$3,465,000\end{array}$

Calculation of estimated total assets for 2017,

Given,

Value of total assets for 2016 is $2,700,000.

The assets should grow at the same rate as sales, which is 10%.

Calculation of the total assets,

$\begin{array}{c}\text{Estimated}\text{assets}\text{for}2017=\text{Assets}\text{of}2016+\text{Increment}\text{in}\text{assets}\\ =\$2,700,000+\left(\$2,700,000\times 10\%\right)\\ =\$2,700,000+\$270,000\\ =\$2,970,000\end{array}$

Calculation of estimated cash for 2017,

Given,

Value of cash for 2016 is $180,000.

The assets should grow at the same rate as sales, which is 10%.

Calculation of estimated cash for 2017,

$\begin{array}{c}\text{Estimated}\text{cash}\text{for}2017=\text{Cash}\text{of}2016+\text{Increment}\text{in}\text{cash}\\ =\$180,000+\left(\$180,000\times 10\%\right)\\ =\$180,000+\$18,000\\ =\$198,000\end{array}$

Calculation of estimated receivable for 2017,

Given,

Value of receivable for 2016 is $360,000.

The assets should grow at the same rate as sales, which is 10%.

Calculation of estimated receivable for 2017,

$\begin{array}{c}\text{Estimated}\text{receivable}\text{for}2017=\text{Recivable}\text{of}2016+\text{Increment}\text{in}\text{receivable}\\ =\$360,000+\left(\$360,000\times 10\%\right)\\ =\$360,000+\$36,000\\ =\$396,000\end{array}$

Calculation of estimated inventories for 2017,

Given,

Value of inventories for 2016 is $720,000.

The assets should grow at the same rate as sales, which is 10%.

Calculation of estimated inventories for 2017,

$\begin{array}{c}\text{Estimated}\text{inventories}\text{for}2017=\text{Inventories}\text{of}2016+\text{Increment}\text{in}\text{inventories}\\ =\$720,000+\left(\$720,000\times 10\%\right)\\ =\$720,000+\$72,000\\ =\$792,000\end{array}$

Calculation of estimated fixed assets for 2017,

Given,

Fixed assets for 2016 are $1,440,000.

The assets should grow at the same rate as sales, which is 10%.

Calculation of estimated fixed assets for 2017,

$\begin{array}{c}\text{Estimated}\text{fixed}\text{assets}\text{for}2017=\text{Fixed}\text{assets}\text{of}2016+\text{Increment}\text{in}\text{fixed}\text{assets}\\ =\$1,440,000+\left(\$1,440,000\times 10\%\right)\\ =\$1,440,000+\$144,000\\ =\$1,584,000\end{array}$

Calculation of estimated total liabilities (excluding retained earnings and common stock) for 2017,

Given,

The liabilities-to-assets ratio for 2017 is 30%.

Estimated assets for 2017 are 2,970,000.

Calculation of estimated liabilities (excluding retained earnings and common stock) for 2017,

$\begin{array}{c}\text{Liabilities}\text{to}\text{assets}\text{ratio}=\frac{\text{Liabilities}}{\text{Assets}}\\ 30\%=\frac{\text{Liabilities}}{\$2,970,000}\\ \text{Liabilities}=\$2,970,000\times 30\%\\ \text{Liabilities}=\$891,000\end{array}$

Calculation of estimated interest for 2017,

Given,

Forecasted notes payable for 2017 are $728,000.

Forecasted long terms debts are $891,000.

Interest rate is 12.5%.

Calculation of estimated interest,

$\begin{array}{c}\text{Interest}=\text{Total}\text{debts}\times \text{Rate}\text{of}\text{interest}\\ =\left(\text{\$}163,000+\$728,000\right)\times 12.5\%\\ =\text{\$}891,000\times \text{12}\text{.5\%}\\ =\text{\$111,375}\end{array}$

Calculation of taxes

Given,

Tax rate is 40%

EBT for the year 2017 is $383,625.

Calculation of taxes,

$\begin{array}{c}\text{Taxes}=\text{EBT}\times \text{Tax}\text{ratio}\\ =\$383,625\times 40\%\\ =\$153,450\end{array}$

Calculation of Earnings per share,

Given,

Estimated net income for 2017 is $230,175.

Shares outstanding are 100,000.

Calculation of EPS,

$\begin{array}{c}\text{EPS}=\frac{\text{Net}\text{income}}{\text{Shares}\text{outstanding}}\\ =\frac{\text{\$}230,175}{100,000}\\ =\text{\$2}\text{.30}\text{per}\text{share}\end{array}$

Calculation of dividend paid in 2016,

Given,

Dividend per share for 2016 is $1.08.

Shares outstanding for 2016 is 100,000

Formula to calculate Dividend paid in 2016,

$\begin{array}{c}\text{Dividend}\text{paid}=\text{Dividend}\text{per}\text{share}\times \text{Shares}\text{outstanding}\\ =\$1.08\times 100,000\\ =\$108,000\end{array}$

Calculation of dividend payout ratio,

Given,

Dividend paid for the year 2016 is $108,000.

Net income for the year 2016 is $180,000.

Calculation of the dividend payout ratio,

$\begin{array}{c}\text{Dividend}\text{payout}\text{ratio}=\frac{\text{Dividend}\text{paid}}{\text{Net}\text{income}}\times 100\\ =\frac{\$108,000}{\$180,000}\times 100\\ =60\%\end{array}$

Calculation of dividend paid during 2017

Given

Dividend payout ratio remains constant, which is 60%.

Net income for the year 2017 is $230,175.

Calculation of dividend paid during 2017,

$\begin{array}{c}\text{Dividend}\text{paid}\text{during}2017=\left(\begin{array}{l}\text{Net}\text{income}\text{for}\text{the}\text{year}2017\\ \times \text{Dividend}\text{payout}\text{ratio}\end{array}\right)\\ =\$230,175\times 60\%\\ =\$138,105\end{array}$

Calculation of estimated dividend per share for 2017,

Given,

Dividend paid during 2017 is $138,105.

Shares outstanding are 100,000.

Calculation of dividend per share,

$\begin{array}{c}\text{Dividend}\text{per}\text{share}=\frac{\text{Dividend}\text{paid}}{\text{Shares}\text{outstanding}}\\ =\frac{\$138,105}{100,000}\\ =\$1.38\end{array}$

Calculation of estimated value of common stock for 2017,

Given,

Estimated total assets for 2017 are $2,970,000.

Estimated liabilities (excluding retained earnings and common stock) are $891,000

Estimated retained earnings for 2017 are $92,070.

Calculation of common stock for 2017,

$\begin{array}{c}\text{Common}\text{stock}\text{for}2017=\left[\begin{array}{l}\text{Total}\text{assets}\\ -\text{Liabilities}\left(\begin{array}{l}\text{excluding}\text{retained}\\ \text{earnings}\text{and}\text{common}\text{stock}\end{array}\right)\\ -\text{Retained}\text{earnings}\end{array}\right]\\ =\$2,970,000-\$891,000-\$296,070\\ =\$1,782,930\end{array}$

Conclusion

The forecasted notes payable for 2017 are $728,000, the forecasted long term debts are $163,000 and the addition in retained earnings are 92,070.

Summary Introduction

To find: Firm’s sustainable growth rate in sales.

Explanation of Solution

Calculation of sustainable growth rate,

Given,

The profit margin is 5%.

The dividend payout ratio is 60%.

Current sales for 2017 are $3,960,000.

Total assets for 2017 are $2,970,000.

Spontaneous current liability for 2017 is $891,000.

Formula to calculate sustainable growth rate in sales,

$\text{Sustainable}\text{growth}\text{rate}=\frac{\left[\begin{array}{l}\text{Profit}\text{margin}\times \left(1-\text{Payout}\text{ratio}\right)\\ \times \text{Current}\text{sales}\end{array}\right]}{\left[\begin{array}{l}\text{Total}\text{assets}-\text{Spontaneous}\text{current}\text{liability}\\ -\left(\text{Profit}\text{margin}\times \left(1-\text{payout}\text{ratio}\right)\times \mathrm{Current}sales\right)\end{array}\right]}\times 100$

Substitute 5% (or 0.05) for profit margin, 6% (or 0.6) for payout ratio, $3,960,000 for current sales, $2,970,000 for total assets and $891,000 for spontaneous current liability.

$\begin{array}{c}\text{Sustainable}\text{growth}\text{rate}=\frac{0.05\times \left(1-0.6\right)\times 3,960,000}{2,970,000-\$891,000-\left(0.05\left(1-0.6\right)\times 3,960,000\right)}\times 100\\ =\frac{79,200}{1,999,800}\times 100\\ =3.96\%\end{array}$

Conclusion

The sustainable growth rate is 3.96%.