Question

AFN EQUATION

Carlsbad Corporation's sales are expected to increase from $5 million in 2016 to $6 million in 2017, or by 20%. Its assets totaled $4 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. Its profit margin is forecasted to be 6%.

a Assume that the company pays no dividends.
Under these assumptions, what would be the additional funds needed for the coming year? Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.
$

b Why is this AFN different from the one when the company pays dividends?

1. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of additional funds needed.
2. Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of assets needed.
3. Under this scenario the company would have a higher level of spontaneous liabilities, which would reduce the amount of additional funds needed.
4. Under this scenario the company would have a lower level of retained earnings, which would increase the amount of additional funds needed.
5. Under this scenario the company would have a lower level of retained earnings, which would decrease the amount of additional funds needed.

Answer 1

Answer (a):

AFN = (Assets / Sales) * (Δ Sales) - ((Accounts payable + Accrued liabilities) / Sales) x (Δ Sales) - (Profit Margin % * Forecast Sales * (1 - dividend payout %))

Δ Sales = 6 - 5 = $1 million = $1,000,000

AFN = 4000000 / 5000000 * 1000000 - (250,000 + 250,000) / 5000000 * 1000000 - (6% * 6000000 * (1 - 0%)

= $340,000

Additional funds needed for the coming year = $340,000

Answer (b):

IV. Under this scenario the company would have a lower level of retained earnings, which would increase the amount of additional funds needed.

Explanation:

The formula for AFN is:

AFN = (Assets / Sales) * (Δ Sales) - ((Accounts payable + Accrued liabilities) / Sales) x (Δ Sales) - (Profit Margin % * Forecast Sales * (1 - dividend payout %))

From the formula, we observe payment or nonpayment of dividend will impact AFN. AFN will be higher if dividend payout is higher.

If dividends are paid, retained earnings will be lower resulting in higher AFN to finance assets to support increase in activity level of operations.

As such option IV is correct and other options I, II, III and V are incorrect.