Question

1. Complete questions: Define each of the following terms:

a. Operating plan; financial plan

b. Spontaneous liabilities; profit margin; payout ratio

c. Additional funds needed (AFN); AFN equation; capital intensity ratio; self-supporting growth rate

d. Forecasted financial statement approach using percentage of sales e. Excess capacity; lumpy assets; economies of scale

f. Full capacity sales; target fixed assets to sales ratio; required level of fixed assets

2. Complete problem: Premium for Financial Risk XYZ, Inc. has an unlevered beta of 1.0. They are financed with 50% debt and has a levered beta of 1.6. If the risk-free rate is 5.5% and the market risk premium is 6%, how much is the additional premium that XYZ, Inc. shareholders require to be compensated for financial risk? Show your work.

Answer 1

Question 1

a) Operating Plan : An operating plan is a short term, highly detailed plan formulated by management to achieve tactical objectives.

Financial Plan : A financial plan is a comprehensive document that includes details about your cash flow, savings, debts, investments, insurance and other elements of your financial life. A good financial plan takes the stress out of setting and prioritizing goals, and maps out clear strategies for achieving them.

b) Spontaneous Liabilities : Spontaneous liabilities are the obligations of a company that are accumulated automatically as a result of the company's day-to-day business. An increase in spontaneous liabilities is normally tied to an increase in a company's cost of goods sold (or cost of sales), which are the costs involved in production.

Profit Margin : Profit margin is the amount by which revenue from sales exceeds costs in a business. It is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits.

Payout Ratio : The payout ratio shows the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage of the company's earnings. The payout ratio can also be expressed as dividends paid out as a proportion of cash flow. The payout ratio is also known as the dividend payout ratio. Formula : DPR = Total Dividends / Net Income

c) Additional funds needed (AFN) is the amount of money a company must raise from external sources to finance the increase in assets required to support increased level of sales. Additional funds needed (AFN) is also called external financing needed.

Additional funds needed method of financial planning assumes that the company's financial ratios do not change. In response to an increase in sales, a company must increase its assets, such as property, plant and equipment, inventories, accounts receivable, etc. Part of this increase is offset by spontaneous increase in liabilities such as accounts payable, taxes, etc., and part is offset by increase in retained earnings.

AFN Equation : Additional funds needed (AFN) is calculated as the excess of required increase in assets over the increase in liabilities and increase in retained earnings.

Additional Funds Needed
= A0 ×	ΔS	− L0 ×	ΔS	− S1 × PM × b
	S0		S0

Where,
A_o = current level of assets
L_o = current level of liabilities
ΔS/S_o = percentage increase in sales i.e. change in sales divided by current sales
S₁ = new level of sales
PM = profit margin
b = retention rate = 1 – payout rate

A negative figure for additional funds needed means that there is a surplus of capital.

Capital Intensity Ratio : Capital intensity ratio of a company is a measure of the amount of capital needed per dollar of revenue. It is calculated by dividing total assets of a company by its sales. It is reciprocal of total asset turnover ratio.

Self Supporting growth Rate : The sustainable growth rate (SGR) is the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt. The SGR involves maximizing sales and revenue growth without increasing financial leverage.

d) Forecasted financial statement approach using percentage of sales : The percentage of sales method is used to calculate how much financing is needed to increase sales. The method allows for the creation of a balance sheet and an income statement. The equation to calculate the forecasted net income is: Forecasted Sales = Current Sales x (1 + Growth Rate/100).

e) Excess capacity : Excess capacity indicates that demand for a product is less than the amount that the business potentially could supply to the market. When a firm is producing at a lower scale of output than it has been designed for, it creates excess capacity.

Excess capacity = Potential Output - Actual Output

Lumpy Assets : Lumpy assets are assets that can only be purchased in large increments – can't buy half a machine. When saying that the firm is operating at 95% of capacity we refer to the utilization of the fixed assets or the property, plant, and equipment (PP&E).

Economies of Scale : Economies of scale are cost advantages reaped by companies when production becomes efficient. Companies can achieve economies of scale by increasing production and lowering costs. This happens because costs are spread over a larger number of goods. Costs can be both fixed and variable.

The size of the business generally matters when it comes to economies of scale. The larger the business, the more the cost savings. Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors.

f) Full Capacity Sales : Full capacity sales refers to the optimal sales amount, up to which situation a firm does not need the help of any external financing for the assets. It is the amount of sales when machines are 100% utilized.

Target Fixed Assets to Sales Ratio : The fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company's ability to generate net sales from its fixed-asset investments, namely property plan and equipment (PP&E).

The fixed asset balance is used as a net of accumulated depreciation.  A higher fixed asset turnover ratio indicates that a company has effectively used investments in fixed assets to generate sales.

Required Level of Fixed Assets : A fixed asset is a long-term tangible piece of property or equipment that a firm owns and uses in its operations to generate income. Fixed assets are not expected to be consumed or converted into cash within a year. Fixed assets most commonly appear on the balance sheet as property, plant, and equipment (PP&E). Detailed documentation of an organisation’s capital adds to the understanding of the financial wellbeing and estimation of that business. Data including fixed assets and depreciation is additionally utilised by potential financial specialists when they are thinking about whether an organisation is a profitable or non-profitable firm. While deciding the estimation of a fixed asset, the strategy for depreciation must be considered.

Since the value of the assets depreciates as it is utilized, as it ages, or as latest models are presented, it is critical for a firm to enlist and track depreciation from the time of procurement. Fixed assets are incorporated into the asset report at their initial expense, and after that depreciation all through their life until they are sold, supplanted on the accounting report at their residual esteem.