Question

AFN EQUATION

Carlsbad Corporation's sales are expected to increase from $5 million in 2016 to $6 million in 2017, or by 20%. Its assets totaled $3 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. Its profit margin is forecasted to be 7%.

1. Assume that the company pays no dividends.
   Under these assumptions, what would be the additional funds needed for the coming year? Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.
   $
2. 
   
3. Why is this AFN different from the one when the company pays dividends?
   
   1. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of additional funds needed.
   2. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of assets needed.
   3. Under this scenario the company would have a higher level of spontaneous liabilities, which would reduce the amount of additional funds needed.
   4. Under this scenario the company would have a lower level of retained earnings, which would increase the amount of additional funds needed.
   5. Under this scenario the company would have a lower level of retained earnings, which would decrease the amount of additional funds needed.

Answer 1

a. Calculation of Additional Funds Needed or AFN:

AFN = Increase in assets - increase in liabilities - Increase in retained earnings

Increase in assets = current assets * expected increase in 2017

                           = $3,000,000 * 20%

                          = $600,000

Increase in liabilities = Current liabilities * spontaneous increase in 2017

                              = $1,000,000 * 20%

                             = $2,00,000

Increase in retained earnings = 2016 sales * expected increase in 2017 * profit margin * retention ratio

                                          = $5,000,000 * 20% * 7% * 100%

                                          = $1,000,000 * 7% * 100%

                                          = $70,000

AFN = $6,00,000 - $2,00,000 * $70,000

       = $3,30,000

b. The correct answer to the question is (I). Under this scenario, the retained earnings will be high because there is no dividend payout, due to high retained earnings, the additional funds required will be less. If, on the other hand, dividend is being paid, then AFN would be high.