Question

A firm has total asset turnover of 1.25. All assets and accounts payable vary directly with sales. Debt and equity do not vary with sales. Current sales are $1,000 and are expected to grow 10% over the year. Accounts payable are 1% of assets. The firm’s net profit margin is 8% and it expects to pay dividends in the amount of $20.

Calculate the firm’s External Financing Need.

Answer 1

Current Sales = $ 1000

Asset Turn over = 1.25

Sales/ Assets = 1.25

Assets this year = Sales/ 1.25 = 1000/1.25 = $ 800= Debt + Equity

Current Liabilties = Account payable = 1% * Assets = 0.01 * 800 =$ 8

Net Profit this year = 8% * 1000 = $ 80

Dividends = $ 20

Retained earnings = Net Profits - Dividends = (80-20) = $ 60

Assets next year = Assets this year *(1+ 10%) = 800*(1+10%) = $ 880 (ie increase of $ 80 over last year)

EFN = (A/S) x (Δ Sales) - (L/S) x (Δ Sales) - (PM x FS x (1-d))

A / S: Assets that change given a change in sales, expressed as a percentage of sales.

Δ = Symbol for Change

ΔSales: Change in sales between the last reporting period and the forecasted sales.

L / S: Liabilities that change given a change in sales, expressed as a percentage of sales.

PM: Profit Margin on Sales; i.e. net income / sales.

FS: Forecasted Sales

d: dividend payout percent

(1 - d): Percent of earnings retained after paying out dividends; d is the dividend payout ratio.

A/S = 800/1000, ΔSales = $ 80, L/S = 8/1000, PM = 0.08, FS = 880, d = 20/80 = 0.25

EFN =( 0.8* 80) - (0.008*80) -(0.08*880*(1-0.25)) = $ 10.56