Question

2. Factors that affect the AFN equation Several factors affect a firm’s need for external funds. Evaluate the effect of each following factor and place a check next to each factor that is likely to increase a firm’s need for external capital—that is, its AFN (additional funds needed). Check all that apply. The firm increases its dividend payout ratio. The firm previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. The firm’s inventory turnover decreases, with no effect on the sales forecast. Dividends to common shareholders are paid out of after-tax earnings. Do these payouts affect a firm’s AFN? Yes, dividends still affect a firm’s AFN even though they are paid out of after-tax earnings. No, dividends do not affect a firm’s AFN, because they are paid out of after-tax earnings.

Answer 1

We have following formula to calculate additional funds needed (AFN)

Additional Funds Needed (AFN) = A0 * ΔS/S0 − L0 * ΔS/S0 - S1 * PM * b

Where,

A0 = current level of assets

S0 = current sales

ΔS/S0 = percentage increase in sales

L0 = current level of liabilities (spontaneous liabilities)

S1 = Increased sales

PM = profit margin

b = retention rate = 1 – dividend payout rate

therefore, the factors that affect the AFN equation -

· The firm increases its dividend payout ratio. Yes, this factor will affect the AFN equation as it will reduce retention rate and likely to increase a firm’s need for external capital

· The firm previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. No, the assets are underutilized so this factor will not affect the AFN equation

· The firm’s inventory turnover decreases, with no effect on the sales forecast. No, this factor will not affect the AFN equation as there is no effect on the sales forecast.

Dividends to common shareholders are paid out of after-tax earnings. Do these payouts affect a firm’s AFN?

The dividends to common shareholders are paid out of after-tax earnings; it will not affect the AFN, if other things are same.

Therefore correct statement is: No, dividends do not affect a firm’s AFN, because they are paid out of after-tax earnings.