Question

You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.

Last year's sales = S0	$300.0	Last year's accounts payable	$50.0
Sales growth rate = g	40%	Last year's notes payable	$15.0
Last year's total assets = A0*	$500.0	Last year's accruals	$20.0
Last year's profit margin = PM	20.0%	Initial payout ratio	10.0%

Which answer choice is correct?

	a.	$31.9
	b.	$33.6
	c.	$35.3
	d.	$37.0
	e.	$38.9

Answer 1

If Payout Ratio is 10%:

Last Year:

Sales = $300
Total Assets = $500
Profit Margin = 20.00%

Retention Ratio = 1 - Payout Ratio
Retention Ratio = 1 - 0.10
Retention Ratio = 0.90

Spontaneous Current Liabilities = Accounts Payable + Accruals
Spontaneous Current Liabilities = $50 + $20
Spontaneous Current Liabilities = $70

This Year:

Growth Rate = 40%

Sales = $300 + 40% * $300
Sales = $420

Addition to Retained Earnings = Sales * Profit Margin * Retention Ratio
Addition to Retained Earnings = $420 * 20% * 0.90
Addition to Retained Earnings = $75.60

Increase in Total Assets = $500 * 0.40
Increase in Total Assets = $200

Increase in Spontaneous Current Liabilities = $70 * 0.40
Increase in Spontaneous Current Liabilities = $28

Additional Fund Needed = Increase in Total Assets - Increase in Spontaneous Current Liabilities - Addition to Retained Earnings
Additional Fund Needed = $200 - $28 - $75.60
Additional Fund Needed = $96.4

If Payout Ratio is 50%:

Last Year:

Sales = $300
Total Assets = $500
Profit Margin = 20.00%

Retention Ratio = 1 - Payout Ratio
Retention Ratio = 1 - 0.50
Retention Ratio = 0.50

Spontaneous Current Liabilities = Accounts Payable + Accruals
Spontaneous Current Liabilities = $50 + $20
Spontaneous Current Liabilities = $70

This Year:

Growth Rate = 40%

Sales = $300 + 40% * $300
Sales = $420

Addition to Retained Earnings = Sales * Profit Margin * Retention Ratio
Addition to Retained Earnings = $420 * 20% * 0.50
Addition to Retained Earnings = $42.00

Increase in Total Assets = $500 * 0.40
Increase in Total Assets = $200

Increase in Spontaneous Current Liabilities = $70 * 0.40
Increase in Spontaneous Current Liabilities = $28

Additional Fund Needed = Increase in Total Assets - Increase in Spontaneous Current Liabilities - Addition to Retained Earnings
Additional Fund Needed = $200 - $28 - $42
Additional Fund Needed = $130

Change in Additional Fund Needed = $130 - $96.4
Change in Additional Fund Needed = $33.6