Question

The most recent financial statements for Crosby, Inc., follow. Sales for 2018 are projected to grow by 30 percent. Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant. Costs, other expenses, current assets, fixed assets, and accounts payable increase spontaneously with sales.

CROSBY, INC. 2017 Income Statement
Sales				$	765,000
Costs					621,000
Other expenses					30,000
Earnings before interest and taxes				$	114,000
Interest paid					14,800
Taxable income				$	99,200
Taxes (22%)					21,824
Net income				$	77,376
Dividends	$	24,840
Addition to retained earnings		52,536

CROSBY, INC. Balance Sheet as of December 31, 2017
Assets				Liabilities and Owners’ Equity
Current assets				Current liabilities
Cash	$	25,440		Accounts payable	$	62,200
Accounts receivable		34,880		Notes payable		18,200
Inventory		71,600		Total	$	80,400
Total	$	131,920		Long-term debt	$	113,000
				Owners’ equity
Fixed assets				Common stock and paid-in surplus	$	112,000
Net plant and equipment	$	222,000		Retained earnings		48,520
				Total	$	160,520
Total assets	$	353,920		Total liabilities and owners’ equity	$	353,920

What is the EFN if the firm wishes to keep its debt-equity ratio constant? (Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.)

Answer 1

Answer:

Sales for 2018 are projected to grow by 30 percent.

Costs and other expenses increase spontaneously with sales.

Interest expense will remain constant; the tax rate and the dividend payout rate will also remain constant.

As such:

Projected EBIT = 114,000 * (1 + 30%) = $148,200

Interest expense = $14,800

Tax rate = 22%

When debt-equity ratio constant, retention ratio will also remain constant.

Retention ratio = 52,536 / 77,376

Hence:

Projected addition to retained earnings = (148200 - 14800) * (1 - 22%) * 52536 / 77376

= $70,648.21

Firm wishes to keep its debt-equity ratio constant.

Hence:

Total debt can be increased by = Projected addition to retained earnings / Equity * Total debt

= (70648.21 / 160520) * (80400 + 113000)

= $85,119.39

As accounts payable increases spontaneously with sales:

Projected increase in accounts payable = 62200 * 30% = $18,660

As increase in total debt (to keep debt-equity constant) is higher than projected increase in accounts payable, for EFN calculations we do not to consider increase in accounts payable.

EFN = Assets * Growth rate - Projected addition to retained earnings - Increase in total debt (to keep debt-equity constant)

= 353920 * 30% - 70648.21 - 85119.39

= - $49,591.60

EFN = - $49,592 or ($49,592)