Question

You are considering investing in Annie’s Eatery. You have been able to locate the following information on the firm: Total assets are $40 million, accounts receivable are $6.0 million, ACP is 30 days, net income is $4.75 million, debt-to-equity is 1.5 times, and dividend payout ratio is 45 percent. All sales are on credit. Annie’s is considering loosening its credit policy such that ACP will increase to 35 days. The change is expected to increase credit sales by 5 percent. Any change in accounts receivable will be offset with a change in debt. No other balance sheet changes are expected. Annie’s profit margin and dividend payout ratio will remain unchanged. Use the DuPont equation to determine how this change in accounts receivable policy will affect Annie’s sustainable growth rate.

Answer 1

Solution -

Sustainable growth as per DUPont Model-

a)   As per existing policy -

Sustainable growth = (1-payout ratio) X ROE*

                               =    (1- 45%) X 29.6875

                               =   16.328125 %

b) As per proposed policy -

Sustainable growth = (1-payout ratio) X ROE**

                                = (1-45%) X 27.8125

                                = 15.296875 %

Comment- By implementing proposed policy , the sustainable growth rate is affected and reduced by 1.03125 %, hence , anney will loose its income at reduced sustainable growth rate.

Working Note-

ROE* computation for existing policy-

Dupont ROE formula - Net Income/ Revenue X   Revenue/Total Asset   X Total Asset/Equity

                             = 4.75(given)/73(note a) X   73(note a)/40(given)   X 40 (given)/ 16 (note b)

                             = 29.6875

note a-

ACP = 365 days/debtor turnover ratio

30 days (given) = 365 days/(net credit sales/ avg debtor or receivable)

by putting value given for receivable $ 6 m and solving above ,we find

= 365/30 X 6

= $ 73 m approx

note b -

debt to equity ratio = 1.5 times

so formula = debt / equity

it means debt is 1.5 times higher than equity , so let assume equity be x , so debt become 1.5 x (1.5 times higher)

Total asset = Debt + Equity

40 (given) = x + 1.5 x

40 = 2.5 x

so x = 40/2.5 = $16 m

Similar calculation to be followed for proposed ROE

ROE* computation for proposed policy as

Dupont ROE formula - Net Income/ Revenue X   Revenue/Total Asset   X Total Asset/Equity

                             = 4.45(note c)/73 (105%) X   73 (105%) /40(given)   X 40 (given)/ 16 (note b)

                             = 27.8125

note c

current net income = $ 4.75 m

as per proposed policy , the current net income will decrease by $0.30 m , computation as below

ACP = 365 days/ debtor turnover ratio

65 days = 365 days / (net credit sales/AR)

AR = 30 X 73 (105 %) / 365

   = $ 6.30 mn

it means AR increases from $ 6 m to $ 6.3 m so it increase by $ .30mn so reduction in net income by such amount

new Net income = $ 4.75m - $ 0.30 m

                         = $ 4.45m