Chapter 4, Problem 29P

Conn Man’s Shops, a national clothing chain, had sales of $350 million last year. The business has a steady net profit margin of 9 percent and a dividend payout ratio of 25 percent. The balance sheet for the end of last year is shown next.

The firm’s marketing staff has told the president that in the coming year there will be a large increase in the demand for overcoat and wool slacks. A sales increase of 20 percent is forecast for the company.

All balance sheet items are expected to maintain the same percent-of-sales relationships as last year,* except for common stock and retained earnings. No change is scheduled in the number of common stock shares outstanding, and retained earnings will change as dictated by the profits and dividend policy of the firm. (Remember the net profit margin is 9 percent.)

a. Will external financing be required for the company during the coming year?

b. What would be the need for external financing if the net profit margin went up to 10.5 percent and the dividend payout ratio was increased to 60 percent? Explain.

Summary Introduction

To determine: Whether the company requires external finance or not during the coming years.

Introduction:

External Finance:

It is an external/outside source through which a company raises money to accomplish its operations. It can be from the issuance of equity, debt, and loan from banks.

Answer to Problem 29P

The company does not need external finance as the requirement of new funds is negative. It indicates that the company has sufficient fund for its operations.

Explanation of Solution

The calculation of the requirement of the new funds (RNF) is as follows.

$\begin{array}{c}\text{RNF}=\left(\frac{\text{Total Assets}}{\text{Existing Sales}}\times \text{Change in Sales}\right)-\left(\frac{\text{Total Liabilities}}{\text{Existing Sales}}\times \text{Change in Sales}\right)-\\ \left(\text{Profit Margin}\times \text{New Sales}\times \text{Retention Ratio}\right)\\ =\left(\frac{\$280,000,000}{\$350,000,000}\times \$70,000,000\right)-\left(\frac{\text{\$140,000,000}}{\text{\$350,000,000}}\times \$70,000,000\right)-\\ \left(9\%\times \$420,000,000\times 75\%\right)\\ =\$56,000,0000-\$28,000,000-\$28,350,000\\ =\left(-\right)\$350,000\end{array}$

Working notes:

The calculation of the total liabilities is as follows.

$\begin{array}{c}\text{Total Liabilities}=\text{Total Liabilities and Stockholders' Equity}-\text{Common Stock}-\text{Retained Earnings}\\ =\$280,000,000-\$50,000,000-\$90,000,000\\ =\$140,000,000\end{array}$

The calculation of the new sales is as follows.

$\begin{array}{c}\text{New Sales}=\text{Exisiting Sales}+\text{Increase in Sales}\\ =\$350,000,000+\left(\$350,000,000\times 20\%\right)\\ =\$350,000,000+\$70,000,000\\ =\$420,000,000\end{array}$

The calculation of the change in sales is as follows.

$\begin{array}{c}\text{Change in Sales}=\text{New Sales}-\text{Existing Sales}\\ =\$420,000,000-\$350,000,000\\ =\$70,000,000\end{array}$

The calculation of the retention ratio is as follows.

$\begin{array}{c}\text{Retention Ratio}=100\%-\text{Dividend Payout Ratio}\\ =100\%-25\%\\ =75\%\end{array}$

Summary Introduction

To determine: Whether the company requires external finance or not during the coming years when the profit margin increases to 10.5% and dividend payout ratio to 60%.

Introduction:

External Finance:

It is an external/outside source through which a company raises money to accomplish its operations. It can be from the issuance of equity, debt, and loan from banks.

Answer to Problem 29P

Due to an increase in profit margin ratio and dividend payout ratio, the company requires external finance of $10,360,000. An increase in profit margin ratio means that the funds of the company increase when there is an increase in the dividend payout ratio. The funds of the company decrease because the company needs to pay more dividends to its shareholders. The payment of a dividend company requires external finance.

Explanation of Solution

The calculation of the requirement of the new funds (RNF) is as follows.

$\begin{array}{c}\text{RNF}=\left(\frac{\text{Total Assets}}{\text{Existing Sales}}\times \text{Change in Sales}\right)-\left(\frac{\text{Total Liabilities}}{\text{Existing Sales}}\times \text{Change in Sales}\right)-\\ \left(\text{Profit Margin}\times \text{New Sales}\times \text{Retention Ratio}\right)\\ =\left(\frac{\$280,000,000}{\$350,000,000}\times \$70,000,000\right)-\left(\frac{\text{\$140,000,000}}{\text{\$350,000,000}}\times \$70,000,000\right)-\\ \left(10.5\%\times \$420,000,000\times 40\%\right)\\ =\$56,000,0000-\$28,000,000-\$17,640,000\\ =\$10,360,000\end{array}$

Working notes:

The calculation of the total liabilities is as follows.

$\begin{array}{c}\text{Total Liabilities}=\text{Total Liabilities and Stockholders' Equity}-\text{Common Stock}-\text{Retained Earnings}\\ =\$280,000,000-\$50,000,000-\$90,000,000\\ =\$140,000,000\end{array}$

The calculation of the new sales is as follows.

$\begin{array}{c}\text{New Sales}=\text{Exisiting Sales}+\text{Increase in Sales}\\ =\$350,000,000+\left(\$350,000,000\times 20\%\right)\\ =\$350,000,000+\$70,000,000\\ =\$420,000,000\end{array}$

The calculation of the change in sales is as follows.

$\begin{array}{c}\text{Change in Sales}=\text{New Sales}-\text{Existing Sales}\\ =\$420,000,000-\$350,000,000\\ =\$70,000,000\end{array}$

The calculation of the retention ratio is as follows.

$\begin{array}{c}\text{Retention Ratio}=100\%-\text{Dividend Payout Ratio}\\ =100\%-60\%\\ =40\%\end{array}$