Question

Consider the financial statements for New England Corporation provided below.  The company expects sales to increase by 25% in 2019. Its applicable tax rate in 2019 is expected to be 21% (note that this is significantly less than the rate implied by the Income Statement for 2018).  Its dividend payout ratio in 2019 will be exactly the same as what it is in 2018. Accounts payable are the only “spontaneous liability” for this firm.  New England’s management plans to raise any funding needed for growth through long-term debt only.  Its current interest rate on its existing short-term and long-term debt will remain the same for 2019, and it does not propose to pay down any of its existing short-term or long-term debt (so, effectively, it will be able to “roll over” its existing short-term debt at the same rate as it is paying currently).  On any new long-term borrowings in 2019, New England’s creditors have indicated that they will charge 7.25%.

For New England Corporation mentioned above:

A. Estimate the EFN for 2019 using the “Direct Method”.

B. The “direct method” EFN formula has three parts to it. Briefly explain what each part of the formula measures.  No more than 1 sentence is necessary to explain each part.  Make sure to use your own words.

New England Corporation
Income Statement ($ thousands)	2018
Sales	$95,023
Cost of goods sold	63,186
SG&A expense	8,241
Depreciation expense	6,106
EBIT	17,490
Interest expense	6,724
EBT	10,766
Taxes	5,092
Net income	5,674
Allocation of net income:
Dividends	$2,921
Addition to retained earnings	$2,753

Balance Sheet ($ thousands)	31-Dec-18
ASSETS
Current assets
Cash and marketable securities	$7,916
Accounts receivable	$22,854
Inventory	$30,991
Total current assets	$61,761
Net PPE	331,083
Total assets	$392,844
LIABILITIES AND EQUITY
Current liabilities
Accounts payable	$63,250
Short-term debt	$53,258
Total current liabilities	$116,508
Long-term debt	$58,757
Total liabilities	$175,265
Shareholders' equity
Common Stock & Paid-In Capital	$147,400
Retained earnings	$70,179
Total shareholders' equity	$217,579
Total liabilities and shareholders' equity	$392,844

Answer 1

WORKINGS:
New England Corporation			Forecast
Income Statement ($ thousands)	2018		2019
Sales	95023	95023*1.25=	118779
Cost of goods sold	63,186	63186*1.25=	78983
SG&A expense	8,241	8241*1.25=	10301
Depreciation expense	6,106	6106*1.25=	7633
EBIT	17,490		21863
Interest expense	6,724	Same	6724
EBT	10,766		15139
Taxes	5,092	21%*15139=	3179
Net income	5,674		11959	10.07%
	5.97%
Allocation of net income:
Dividends	2921	51.48%	6157
Addition to retained earnings	2753	48.52%	5803

A. EFN=Needed Increase in assets-Corresponding increase in liabilities-Increase in Retained earnings

Needed Increase in assets=

392844*0.25=

98211

Corresponding increase in liabilities=

63250*0.25=

15813

Increase in Retained earnings=

New sales*Profit Margin*Retention ratio

118779*10.07%*48.52%=

5803

(or simply as worked out in the Income Statement)

So, EFN=98211-15813-5803=

76595

B.

EFN=Needed Increase in assets-Corresponding increase in liabilities-Increase in Retained earnings

So the THREE parts are:

Needed Increase in assets---- to support the increase in sales

Corresponding increase in liabilities---ie. Spontaneous to increased activity --trade liabilities incurred -again as a consequence to increased activity.These are subtracted as they provide funds for the firm.

Increase in Retained earnings--- this amount represents the new additions to equity ,which will ,to a certain exytent ,meet the increased need for funding the asset -base increase.