Solutions Manual

CHAPTER 15

FINANCIAL FORECASTING
FOR STRATEGIC GROWTH

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. 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. Accounts payable, accrued wages and accrued taxes increase

spontaneously and proportionately with sales. Retained earnings
increase, but not proportionately.

3. False. At low growth rates, internal financing will take care of the firms
needs.

4. 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.

II. Problems

Problem 1 (Pro Forma Statements)

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

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and balance sheet increases by 15 percent, the pro forma income statement
and balance sheet will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales 26,450 Assets 18,170 Debt 5,980

Costs 19,205 _______ Equity 12,190
Net income 7,245 Total 18,170 Total 18,170

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity Debt

Equity = 18,170 5,980 = 12,190

Equity increased by:

Equity increase = 12,190 10,600 = 1,590

Net income is 7,245 but equity only increased by 1,590; therefore, a

dividend of 5,655 must have been paid. Dividends paid is the additional
financing needed.

Dividend = 7,245 1,590 = 5,655

Problem 2 (Calculating EFN)

An increase of sales to 7,424 is an increase of:

Sales increase = (7,424 6,300) / 6,300 = .18 or 18%

Assuming costs and assets increase proportionally, the pro forma financial
statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales 7,434 Assets 21,594 Debt 12,400

Costs 4,590 _______ Equity 8,744
Net income 2,844 Total 21,594 Total 21,144

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If no dividends are paid, the equity account will increase by the net income,
so:
Equity = 5,900 + 2,844 = 8,744

So the EFN is:

EFN = Total assets Total liabilities and equity

EFN = 21,594 21,144 = 450

Problem 3 (Calculating EFN)

An increase of sales to 21,840 is an increase of:

Sales increase = (21,840 19,500) / 19,500 = .12 or 12%

Assuming costs and assets increase proportionally, the pro forma financial
statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales 21,840 Assets 109,760 Debt 52,500

Costs 16,800 ______ _ Equity 79,208
EBIT 5,040 Total 109,760 Total 99,456
Taxes (40%) 2,016
Net income 3,024

The payout ratio is constant, so the dividends paid this year is the payout
ratio from last year times net income, or:

Dividends = (1,400 / 2,700) (3,024) = 1,568

The addition to retained earnings is:

Addition to retained earnings = 3,024 1,568 = 1,456

And the new equity balance is:

Equity = 45,500 + 1,456 = 46,956

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So the EFN is:

EFN = Total assets Total liabilities and equity

EFN = 109,760 99,456 = 10,304

Problem 4 (Sales and Growth)

The maximum percentage sales increase is the sustainable growth rate. To

calculate the sustainable growth rate, first we need to calculate the ROE,
which is:

ROE = NI / TE
ROE = 8,910 / 56,000 = .1591 or 15.91%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 .30 = .70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE b) / [1 (ROE b)]

Sustainable growth rate = [.1591(.70)] / [1 .1591(.70)] = .1253 or 12.53%

So, the maximum peso increase in sales is:

Maximum increase in sales = 42,000 (.1253) = 5,264.03

Problem 5 (Calculating Retained Earnings from Pro Forma Income)

Assuming costs vary with sales and a 20 percent increase in sales, the pro
forma income statement will look like this:

Jordan Corporation
Pro Forma Income Statement

Sales 45,600.00
Costs 22,080.00
Taxable income 23,520.00
Taxes (34%) 7,996.80
Net income 15,523.20

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The payout ratio is constant, so the dividends paid this year is the payout
ratio from last year times net income, or:

Dividends = (5,200/12,936) (15,523.20) = 6,240.00

And the addition to retained earnings will be:

Addition to retained earnings = 15,523.20 6,240 = 9,283.20

Problem 6 (Applying Percentage of Sales)

Below is the balance sheet with the percentage of sales for each account on
the balance sheet. Notes payable, total current liabilities, long-term debt, and
all equity accounts do not vary directly with sales.

Jordan Corporation
Balance Sheet

Assets () (%)
Current assets
Cash 3,050 8.03
Accounts receivable 6,900 18.16
Inventory 7,600 20.00
Total 17,550 46.18
Fixed assets
Net plant and equipment 34,500 90.79
Total assets 52,050 136.97

Liabilities and Owners equity

Current liabilities
Accounts payable 1,300 3.42
Notes payable 6,800 n/a
Total 8,100 n/a
Long-term debt 25,000 n/a
Owners equity
Common stock and paid-in surplus 15,000 n/a
Retained earnings 3,950 n/a
Total 18,950 n/a
Total liabilities and Owners equity 52,050 n/a

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Problem 7 (External Financing Requirements)

a., b., & c.
Lewis Company
Pro Forma Income Statement
December 31, 2012
(Millions of Pesos)

1st Pass AFN 2nd Pass

2011 (1 + g) 2012 Effects 2012
Sales 8,000 (1.2) 9,600 9,600
Operating costs 7,450 (1.2) 8,940 8,940
EBIT 550 660 660
Interest 150 150 +30* 180
EBT 400 510 480
Taxes (40%) 160 204 192
Net income 240 306 288

Dividends: 1.04 x 1.10 x

150 = 156 150 165 +24** 189
Addition to RE: 84 141 99

* in interest expense = (51 + 248) x 0.10 = 30.

** in 2012 Dividends = 368/16.96 x 1.10 = 24.
in addition to retained earnings = 99 141 = 42.

Lewis Company
Pro Forma Balance Sheet
December 31, 2012
(Millions of Pesos)

1st 2nd
Pass AFN Pass
2011 (1 + g) Additions 2012 Effects 2012
Cash 80 (1.2) 96 96
Accounts
receivable 240 (1.2) 288 288
Inventory 720 (1.2) 864 864
Total current
assets 1,040 1,248 1,248
Fixed assets 3,200 (1.2) 3,840 3,840
Total assets 4,240 5,088 5,088

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Accounts
payable 160 (1.2) 192 192
Accruals 40 (1.2) 48 48
Notes payable 252 252 +51** 303
Total current
liabilities 452 492 543
Long-term debt 1,244 1,244 +248** 1,492
Total debt 1,696 1,736 2,035
Common stock 1,605 1,605 +368** 1,973
Retained
earnings 939 141* 1,080 42*** 1,038
Total liabilities
and equity 4,240 4,421 5,046

AFN = 667 42

*See Income Statement, 1st pass.

** CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x 5,088 = 2,035.
Maximum increase in debt = 2,035 1,736 = 299.
Maximum current liabilities = 1,248/2.3 = 543.
Increase in notes payable = 543 492 = 51.
Increase in long-term debt = 299 51 = 248.
Increase in common stock = 667 299 = 368.
*** in RE = 99 141 = 42.

Problem 8 (Long-term financing needed)

a. Total liabilities and equity = Accounts payable + Long-term debt +

Common stock + Retained earnings
1,200,000 = 375,000 + LTD + 425,000 + 295,000
Long-term debt (LTD) = 105,000

Total debt = Accounts payable + Long-term debt

Total debt = 375,000 + 105,000 = 480,000

Alternatively;

Total debt = Total liabilities and equity Common stock Retained earnings
Total debt = 1,200,000 425,000 295,000 = 480,000

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b. Assets/Sales (A*/S) = 1,200,000/2,500,000 = 48%

Liabilities/Sales (L*/S) = 375,000/2,500,000 = 15%

2012 Sales = (1.25) (2,500,000) = 3,125,000

AFN = (A*/S) (S) (L*/S) (S) PS2 (1 D)

= (0.48) (625,000) (0.15) (625,000) (0.06) (3,125,000) (0.6)

75,000

AFN = 300,000 93,750 112,500 75,000 = 18,750

Problem 9 (Additional Funds Needed)

Cash 100 x 2 = 200

Accounts receivable 200 x 2 = 400
Inventory 200 x 2 = 400
Net fixed assets 500 + 0.0 = 500
Total assets 1,000 1,500

Accounts payable 50 x 2 = 100

Notes payable 150 150*
Accruals 50 x 2 = 100
Long-term debt 400 400
Common stock 100 100
Retained earnings 250 + 40 = 290
Total liabilities and equity 1,000 1,140

AFN = 360

*150 + 360 = 510

Capacity sales = Current sales/0.5 = 1,000/0.5 = 2,000

Target FA/S ratio = 500/2,000 = 0.25

Target FA = 0.25 (2,000) = 500 = Required FA. Since the firm currently
has 500 of FA, no new FA will be required.

Addition to RE = P (S2) (1 Payout ratio) = 0.05 (2,000) (0.4) = 40

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Problem 10 (Additional Funds Needed)

Percent of Sales Table

Cash 5% Accounts payable 30.0%

Accounts receivable 30 Accrued expenses 2.5
Inventory 20
Current assets 55% Current liabilities 32.5%
(spontaneous) (spontaneous)

Sales = 20% (3,000,000) = 600,000

New Sales level = 3,000,000 + 600,000 = 3,600,000

New Funds Required (NFR) = A (S) L (S) PS2 (1 D)

NFR = 55% (600,000) 32.5% (600,000) 8% (3,600,000) (1 7)

NFR = 330,000 195,000 86,400 = 48,600

Problem 11 (Percent-of-sales method)

Sales = (10%) (100,000,000) = 10,000,000

New Sales level = 100,000,000 + 10,000,000 = 110,000,000

New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)

= (85,000,000/100) (10,000,000) (25,000,000/100) (10,000,000)

.07 (110,000,000) (.60)

NFR = 8,500,000 2,500,000 4,620,000 = 1,380,000

Problem 12 (Percent-of-sales method)

a. Sales = (15%) (300,000,000) = 45,000,000

New Sales level = 300,000,000 + 45,000,000 = 345,000,000

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New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)

= (240,000,000/300,000,000) (45,000,000)
(120,000,000/300,000,000) (45,000,000) .08
(345,000,000) (1 .25)

NFR = 36,000,000 18,000,000 20,700,000 = (2,700,000)

A negative figure for new funds required indicated that an excess of

funds (2,700,000) is available for new investment. No external funds
are needed.

b. New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)

= 36,000,000 18,000,000 .095 (345,000,000) (1 .5)

= 36,000,000 18,000,000 16,387,500

NFR = 1,612,500 external funds required

The net profit margin increased slightly, from 8% to 9.5%, which

decreases the need for external funding. The dividend payout ratio
increased tremendously, however, from 25% to 50%, necessitating more
external financing. The effect of the dividend policy change overpowered
the effect of the net profit margin change.

Problem 13 (External Funds Requirement)

a. Sales = (15%) (100,000,000) = 15,000,000

Spontaneous Assets = 5% + 15% + 20% + 40% = 80%

Spontaneous Liabilities = 15% + 10% = 25%

New Sales level = 100,000,000 + 15,000,000 = 115,000,000

New Funds Required (NFR) = A (S) L (S) PS2 (1 D)

NFR = 80% (600,000) 25% (600,000) 10% (115,000,000) (1 .5)

NFR = 12,000,000 3,750,000 5,750,000 = 2,500,000

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b. If Mercury reduces the payout ratio, the company will retain more
earnings and need less external funds. A slower growth rate means that
less assets will have to be financed and in this case, less external funds
would be needed. A declining profit margin will lower retained earnings
and forced Mercury to seek more external funds.

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