PART (A) 1.

chapter 4 : Mini case study ( Planning for growth at S&S Air): Answer:

1. To calculate the internal growth rate, we first need to find the ROE and the retention ratio, so: ROE = NI / TA ROE $1,537,452/ $18,308,920 ROE = 0.0839 or 8.39% b = Addition to RE / NI b = $977,452 / $1,537,452 b = 0.635 or 63.5%

Now we can use the internal growth rate equation to get : Internal growth rate = (ROA*b) / {1-(ROA*b)} Internal growth rate = {0.0839(0.635)}/{1-(0.0839(0.635)} Internal growth rate = 0.0562 or 5.62% To find subtainable growth, we need to the ROE, which is : ROE = NI/TE
$1,537,452/$10,069,920 = 0. 1526 or 15.26% Using the retention ratio we previousely calculated, the subtainable growth rate is : Subtainable growth rate = (ROA*b) / {1-(ROA*b)} Subtainable growth rate = 0.1526(0.635)}/{1-(0.1526(0.635)} Subtainable growth rate = 0.1072 or 10.72%

The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. On the other hand subtainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earning and current capital structure.

2. The external financing required for 12% sales growth assuming full capacity utilization: EFN= change in Asset change in liabilities change in retained earning - Change in asset = 0.12*18,308,920 = 2,197,070 - Change in liabilitiea = 0.12 * 889,000 = 106,680 - Change in Ret. Earn. = (30,499,420 22,224,580 3,867,500)* 1.12 1,366,680 = 3,569,541 EBT(1) = EBIT(1) I = 3,569,541 478,240 = 3,091,301 Chge. Ret. Earn. = EBT* (1- t) * (b) = 3,091,301 * (1-.40) * .6358 = 1,179,270 EFN = 2,197,070 106,680 1,179,270 = 911,120

Lets look at the pro-forma statements to verify our EFN result. Pro forma Income statement (12% growth rate)

Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income $ 34,159,350 24,891,530 4,331,600 1,366,680 $ 3,569,541 478,240 $ 3,091,301 1,236,520 $ 1,854,780

Dividends Add to RE

675,583 1,179,197

Pro forma balance sheet ( 12% growth rate)

Balance sheet Assets Current Assets Cash Accounts rec. Inventory Total CA $ 493,920 793,408 1,161,574 $ 2,448,902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $

995,680 2,030,000 3,025,680 5,320,000

Fixed assets Net PP&E Total Assets

$ 18,057,088 $ 20,505,990

350,000 10,899,117 $ 11,249,117 $ 19,594,797

So, the EFN is: EFN = Total assets Total liabilities and equity EFN = $20,505,990 19,594,797 EFN = $911,193 (a small difference due to rounding error)

3. Let us assume that the company can only build in amounts of $5 million. We will assume that the company will go ahead with the fixed asset acquisition. In this case, the pro forma financial statement calculation will change slightly. Before, we made the assumption that depreciation increased proportionally with sales, which makes sense if fixed assets increase proportionally with sales. This is not the case now. To estimate the new depreciation charge, we will find the current depreciation as a percentage of fixed assets, then, apply this percentage to the new fixed assets. The depreciation as a percentage of assets this year was:

Depreciation percentage = $1,366,680 / $16,122,400 Depreciation percentage = .0.0847 or 8.47% The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16,122,400+ 5,000,000 = $21,122,400 So, the pro forma depreciation as a percentage of sales will be: Pro forma depreciation = .0847($21,122,400) Pro forma depreciation = $1,789,067

Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income Dividends Add to RE $ 34,159,350 24,891,530 4,331,600

1,789,067
$ 3,147,153 478,240 $ 2,668,913 1,067,565 $ 1,854,780 $ 675,583 1,179,197

The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The fixed asset account will increase by $5 million, rather than the growth rate of sales.

Balance sheet Assets Current Assets Cash Accounts rec. Inventory Total CA $ 493,920 793,408 1,161,574 $ 2,448,902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $

995,680 2,030,000 3,025,680 5,320,000

Fixed assets Net PP&E Total Assets

$ 21,122,400 $ 23,571,302

350,000 10,737,439 $ 11,249,117 $ 19,433,119

So, the EFN is: EFN = Total assets Total liabilities and equity EFN = $23,571,302 19,433,119 EFN = $4,138,183 Because fixed assets increase more rapidly, the depreciation expense will increase at a rate that is faster than sales growth. Sales, profits and retained earnings contribute proportionately less to the total financing required (Ret. Earn. declines), and Liabilities (spontaneous liability growth) will contribute less to the total financing required. So, EFN has to increase