Question

arvard Prep Shops, a national clothing chain, had sales of $350 million last year. The business has a steady net profit margin of 20 percent and a dividend payout ratio of 30 percent. The balance sheet for the end of last year is shown below:

Balance Sheet December 31, 20XX ($ millions)
Assets		Liabilities and Shareholders' Equity
Cash	$4	Accounts payable	$45
Account receivable	12	Accrued expenses	11
Inventory	60	Other payables	28
		Common stock	70
Plant and equipment	190	Retained earnings	112
Total assets	$266	Total liabilities and equity	$266

Harvard’s anticipates a large increase in the demand for tweed sport coats and deck shoes. A sales increase of 30 percent is forecast.

All balance sheet items are expected to maintain the same percent-of-sales relationships as last year, except for common stock and retained earnings. No change in the number of common shares outstanding is scheduled, and retained earnings will change as dictated by the profits and dividend policy of the firm.

a. Will external financing be required for the Prep Shop during the coming year?

• Yes

• No

b. What would the need for external financing be if the net profit margin went up to 25 percent and the dividend payout ratio was increased to 65 percent? (Enter the answer in millions. Round the final answer to 2 decimal places.)

Required new funds           $  million

Answer 1

(a) The extra financing needed can be calculated by the following formula :-

Additional Funds Needed =  

where, A = Assets

S = Sales

L = Liabilities

= change in sales

P = net profit margin percentage

S₂ = Total increased amount of sales / New sales level

D = Dividend Payout ratio

(1 - D) = retention ratio

As per the given data,

S = $350 million = $350,000,000

= 30% * S

Or, = (0.30 * $350,000,000) = $105,000,000

S₂ = ($350,000,000 + $105,000,000) = $455,000,000

A = $266 million

P = 20% or, 0.20

D = 30% or, 0.30

L = $112 million

Therefore, substituting the above corresponding values in the AFN formula, we get,

AFN =

= {(266/350) * 105,000,000} - {(112/350) * 105,000,000} - {0.20 * 455,000,000 * (1 - 0.30)}

= (0.76 * 105,000,000) - (0.32 * 105,000,000) - (0.20 * 0.70 * 455,000,000)

= (79,800,000 - 33,600,000 - 63,700,000)

= (17,500,000)

Hence, the extra financing needed is -$17,500,000. The negative figure of additional funds needed means an excess funds of $17,500,000 is available for new investment. Therefore, no external funds needed.

(b) Under the new condition :-

P i.e. the net profit margin ratio = 0.25

D i.e. the dividend payout ratio = 0.65

Therefore, AFN =

= {(266/350) * 105,000,000} - {(112/350) * 105,000,000} - {0.25 * 455,000,000 * (1 - 0.65)}

= (0.76 * 105,000,000) - (0.32 * 105,000,000) - (0.25 * 0.35 * 455,000,000)

= (79,800,000 - 33,600,000 - 39,812,500)

= 6,387,500

Thus, the additional funds needed = $6,387,500.

The net profit margin has increased by 5% from 20% to 25%, which decreases the additional funds needed. However, the dividend payout ratio increased substantially from 30% to 65%, necessiating additional funds. Thus the change in dividend policy overpowered the marginal increase in the net profit margin.