Question

2. More on the AFN (Additional Funds Needed) equation

Fuzzy Button Clothing Company reported sales of $743,000 at the end of last year; but this year, sales are expected to grow by 6%. Fuzzy Button expects to maintain its current profit margin of 20% and dividend payout ratio of 10%. The firm’s total assets equaled $475,000 and were operated at full capacity. Fuzzy Button’s balance sheet shows the following current liabilities: accounts payable of $65,000, notes payable of $40,000, and accrued liabilities of $70,000. Based on the AFN (Additional Funds Needed) equation, what is the firm’s AFN for the coming year?

-$145,637

-$139,569

-$121,364

-$115,296

A negatively-signed AFN value represents:

A surplus of internally generated funds that can be invested in physical or financial assets or paid out as additional dividends.

A point at which the funds generated within the firm equal the demands for funds to finance the firm’s future expected sales requirements.

A shortage of internally generated funds that must be raised outside the company to finance the company’s forecasted future growth.

Because of its excess funds, Fuzzy Button is thinking about raising its dividend payout ratio to satisfy shareholders. What percentage of its earnings can Fuzzy Button pay to shareholders without needing to raise any external capital? (Hint: What can Fuzzy Button increase its dividend payout ratio to before the AFN becomes positive?)

87.0%

65.3%

60.9%

78.3%

Answer 1

Additional Funds Needed [AFN] for the coming year

Expected Next Year Sales

Expected Next Year Sales = Last Year Sales x 107%

= $743,000 x 106%

= $787,580

After Tax profit Margin

After Tax profit Margin = Expected Next Year Sales x Profit Margin

= $787,580 x 20%

= $157,516

Dividend Pay-out

Dividend Pay-out = After Tax profit Margin x Dividend Pay-out Ratio

= $157,516 x 10%

= $15,752

Additions to Retained Earnings

Additions to Retained Earnings = After Tax profit Margin - Dividend Pay-out

= $157,716 - $15,752

= $141,764

Increase in Total Assets

Increase in Total Assets = Total Assets x Percentage of Increase in sales

= $475,000 x 6%

= $28,500

Increase in Spontaneous liabilities

Increase in Spontaneous liabilities = [Accounts Payable + Accruals] x Percentage of Increase in sales

= [$60,000 + $75,000] x 6%

= $135,000 x 6%

= $8,100

Additional Funds Needed [AFN]

Therefore, the Additional Funds Needed [AFN] = Increase in Total Assets – Increase in in Spontaneous liabilities – Additions to retained earnings

= $28,500 - $8,100 - $141,764

= -$121,364 (Negative AFN)

“Hence, the firm’s AFN for the coming year would be = -$121,364 (Negative AFN)”

A negatively signed AFN value represents “a surplus of internally generated funds, that can be invested in physical or financial assets or paid out as additional dividends”

The Revised Dividend Payout Ratio which equals the AFN to Zero

The Excess AFN for the coming year = $121,364

Expected Dividend Payment for the next year = $15,752

The Revised Dividend Payment which equals the AFN to Zero = $121,364 + $15,752

= $137,116

Therefore, the Dividend Pay-out Ratio = [Dividend Payment / After Tax profit Margin] x 100

= [$137,316 / $157,516] x 100

= 87.0%

“Hence, the Button should increase the Dividend Pay-out Ratio to 87.0%”