Chapter 4, Problem 26QP

Calculating EFN [LO2] In Problem 24, suppose the firm wishes to keep its debt–equity ratio constant. What is EFN now?

Summary Introduction

To determine: External financing needed.

Introduction:

The difference between the total assets and the total liabilities and owner’s equity is termed as external financing needed. This difference amount is the source or funds, which is required from the outside sources.

Answer to Problem 26QP

External financing needed is $55,345.

Explanation of Solution

Given information:

The firm would like to keep its debt equity ratio, constant.

A sale for the year 2015 is projected to grow by 20%.

Interest expenses, tax rate, dividend payout ratio remains constant whereas cost, other expenses, current assets, fixed assets, accounts payable vary with sales.

Formulae:

$\text{New debt}=\text{Debt equity ratio}\times \text{Total equity}$

$\text{Debt equity ratio}=\frac{\text{Current laibilities}+\text{Longterm Debt}}{\text{Total equity}}$

$\text{EFN}=\text{New total debt}-\left(\begin{array}{l}\text{BeginningLTD}+\text{BeginningCL}\\ +\text{Spontaneous increase in accounts payable}\end{array}\right)$

Balance sheet after increase in sales by 20%

Pro forma balance sheet
Particulars	Amount ($)	Particulars	Amount ($)
Current assets		Current liabilities
Cash	$29,136	Accounts payable	$78,240
Accounts receivable	$44,484	Notes payable	$16,320
Inventory	$100,080	Total	$94,560
Total	$173,700
Fixed assets		Long-term debt	$155,000
Net plant and equipment	$475,800	Owner's equity
		Common stock and paid in surplus	$130,000
		Retained earnings	$262,837
		Total equity	$392,837
Total	$649,500	Total	$642,397

Compute new total debt:

$\text{New debt}=\text{Debt equity ratio}\times \text{Total equity}$

Compute debt equity ratio:

$\begin{array}{c}\text{Debt equity ratio}=\frac{\text{Current liabilities}+\text{Longterm Debt}}{\text{Total equity}}\\ =\frac{\$81,520+\$155,000}{\$304,730}\\ =\frac{\$236,520}{\$304,730}\\ =0.7762\end{array}$

Hence, debt equity ratio is 0.77616.

$\begin{array}{c}\text{New debt}=\text{0}\text{.7762}\times \text{\$392,837}\\ =\text{\$304,905}\end{array}$

Hence, new debt is $304,905.

The below mentioned calculations are required to compute EFN:

Note: The external financing needed is determined from the external sources and do not increase spontaneously with sales. Therefore, the spontaneous increase from the accounts payable has to be subtracted.

$\begin{array}{c}\text{New accounts payable}=\text{Existing accounts payable}\times \text{0}\text{.20}\\ =\text{\$65,200}\times \text{0}\text{.20}\\ =\text{\$13,040}\end{array}$

Hence, new level of accounts payable is $13,040.

Thus, $13,040 shows the spontaneous increase in accounts payable and the debt that is raised externally is termed as external financing needed.

Compute EFN:

$\begin{array}{c}\text{EFN}=\text{New total debt}-\left(\begin{array}{l}\text{BeginningLTD}+\text{BeginningCL}\\ +\text{Spontaneous increase in accounts payable}\end{array}\right)\\ =\text{\$304,905}-\left(\text{\$155,000}+\text{\$78,240}+\text{\$16,320}\right)\\ =\text{\$55,345}\end{array}$

Hence, external financing needed is $55,345.

Since, an increase in debt will make balance sheet unbalanced.

The new balance sheet is shown below:

$\begin{array}{c}\text{Longterm debt}=\$155,000+\$55,345\\ =\$210,345\end{array}$

Adjusted pro forma Balance:

Total asset is $649,500

Total liabilities and owner’s equity is $697,743

The balance of $697,743 and $649,500 is $48,243 that can be transferred to excess cash account.

Compute the balance sheet after taking these adjustments into account:

Any increase in fixed assets will change the firms operation. Since, the company already has enough fixed asset, the debts and equities can be repurchased in its capital structure weights.

The company’s debt-assets and equity assets are as follows:

$\begin{array}{c}\text{Debt assets}=\frac{\text{Debt equity ratio}}{1+\text{Debt equity ratio}}\\ =\frac{0.7762}{1+07762}\\ =0.44\end{array}$

$\text{Total debt}=\text{debt asset}\left(\text{Total assets}\right)$

$\begin{array}{c}\text{Total debt needed}=\text{0}\text{.44}\left(\$649,500\right)\\ =\$283,824\\ \text{Total equity needed}=0.56\left(\$649,500\right)\\ =\$365,676\end{array}$

$\begin{array}{c}\text{Debt repurchase}=\text{Total current liabilities}+\text{Long term debt}-\text{Total debt needed}\\ =\left(\$94,560+\$210,345\right)-\$283,824\\ =\$21,081\end{array}$

$\begin{array}{c}\text{Equity repurchase}=\text{Existing equity}-\text{Total equity needed}\\ =\text{\$392,837}-\text{\$365,676}\\ =\text{\$27,161}\end{array}$

Consider all the debts are from long-term debt and all equities are from retained earnings:

Compute the final pro forma balance sheet:

Pro forma balance sheet
Particulars	Amount ($)	Particulars	Amount ($)
Current assets		Current liabilities
Cash	$29,136	Accounts payable	$78,240
Accounts receivable	$44,484	Notes payable	$16,320
Inventory	$100,080	Total	$94,560
Total	$173,700
Fixed assets		Long-term debt	$189,264
Net plant and equipment	$475,800	Owner's equity
		Common stock and paid in surplus	$130,000
		Retained earnings	$235,676
		Total equity	$365,676
Total	$649,500	Total	$649,500