Cristopher T.

Tubong BSA 2A

Module 3 - Activity 1
Answer the following problems in from your textbook. This is a graded activity.
1.

Problem 6-2, pg. 221

Carter Corporation’s sales are expected to increase from $5 million in 2015
to $6 million in 2016, or by 20%. Its assets totaled $3 million at the end of 2015.
Carter is at full capacity, so its assets must grow in proportion to projected
sales. At the end of 2015, 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 in forecasted to be 5%, and the forecasted retention
ratio is 30%. Use the AFN equation to forecast the additional funds Carter will
need for the coming year.
AFN EQUATION. Refer to problem 6-1. what additional funds would be
needed if the company’s year-end 2015 assets had been $4 million? Assume
that all other numbers are the same. Why is this AFN different from the one you
found in problem 6-1? is the company’s “capital intensity” the same or different?
Explain.

Solution:
Sales Growth Rate = $6 million - $4 million / $4 million
= 50%
Spontaneous increase in liabilities = 2015 liabilities x Sales growth rate
= $1,000,000 x 50%
= $500,000
Increase in retained earnings = 2016 sales x profit margin x retention rate
= 6,000,000 x 5% x 30%
= $90,000
Increase in assets = 2015 assets x Sales growth rate
= 3,000,000 x 50%
= $1,500,000
Additional funds needed = Increase in assets - Increase in liabilities - Increase
in retained earnings
= 1,500,000 - 500,000 - 90,000
= $910,000
Hence, Cater Corporation will need $910,000 to finance the increased level
of sales. This AFN is different from the previous problem because the sales
growth rate changed from 20% to 50%. Its capital intensity will also change
from 0.60 to 0.75 as a result form the increased sales growth rate.
Problem 6-5, pg. 222
EXCESS CAPACITY. Walter Industries has $5 billion in sales and %1.7
billion in fixed assets. Currently, the company’s fixed assets are operating at
90% of capacity.
a. What level of sales could Walter Industries obtained if it had been
operating at full capacity?
b. What is Walter’s target fixed assets/sales ratio?
c. If Walter’s sales increase 12% how large of an increase in fixed assets will
the company need to meet its target fixed assets/sales ratio?
Solution:
a. Sales at Full Capacity = Actual Sales / Capacity
= $5 million/90%
= $5,555,555,556
b. Fixed assets/Sales = $1.7/5.0
= 0.34
c. Sales increase by 12% = $5.0 billion (1.12)
= $5.6 billion
Target Fixed Asset/Sales Ratio = Old F/S Ratio x New Sales
= 0.34 x $5.6 billion
= $1.904 billion
Needed increase in Fixed Assets = $1.7 billion - $1.904 billion
=$0.204B, or $204M is the needed increase in fixed assets to meet its target
fixed assets/sales ratio.

Problem 6-7, pg. 222-223

PRO FORMA INCOME STATEMENT. At the end of last year, Roberts Inc.
Reported the following income statement (in million of dollars):
Sales $3,000

Operating Cost excluding depreciation 2,450

EBITDA $ 550
Depreciation 250
EBIT $ 300
Interest 125
EBT $ 175
Taxes (40%) 70
Net Income $ 105
 Looking ahead to the followingyear, the company’s CFO has assembled this
information:
 Year-end Sales are expected to be 10% higher than the $3 billion in sales
generated last year.
 Year-end operating costs, excluding depreciation, are expected to equal
80% of year-end sales.
 Depreciation is expected to increase at the same rate as sales.
 Interest costs are expected to remain unchanged.
 The tax rate is expected to remain at 40%
On the basis of that information, what will be the forecast for Roberts
year-end income.

Solution:
Sales = $ 3 billion x 1.10
=$3.3 billion
Operating Cost excluding depreciation = $3.3 billion x 80%
=$2.640 billion
Depreciation = $250 million x 1.10
=$275 million

Sales $3,300

Operating Cost excluding depreciation 2,640

EBITDA $ 660
Depreciation 275
EBIT $ 385
Interest 125
EBT $ 260
Taxes (40%) 104
Net Income $ 156
Hence, the projected net income of Roberts Inc. Based on the given
information of the company’s CFO is $156 million.
Problem 6-9, pg. 223
SALES INCREASE. Pierce Furnishings generated $2 million in sales during
2015, and its year-end total assets were $1.5 million. Also, at year-end 2015,
current liabilities were $500,000, consisting of $200,000 of notes payable,
$200,000 accounts payable, and $100,000 of accrued liabilities. Looking ahead
to 2016, the company estimates that its assets must increase by $0.75 for
every $1.00 increase in sales. Pierce’s profit margin is 5%, and its retention
ratio is 40%. How large of a sales increase can the company achieve without
having to raise funds externally?
Solution:
Here given,
Sales in 2015, S0 = $2,000,000
Spontaneous assets, A* = $1,500,000
Notes Payable in 2015 = $200,000; Accounts Payable in 2015 = $200,000;
Accruals in 2015 = $100,000;
Therefore, Spontaneous liabilities, L* = Accounts Payable + Accruals =
$200,000 + $100,000 = $300,000
Profit Margin, PM = 5%
Payout ratio, DPR or POR = 60%.
Then, a sales increment (∆S) that the company can achieve without having to
raise funds externally (AFN = $0); that is, its self-supporting growth rate = ?
We have,
AFN = (A*/S0)∆S - (L*/S0)∆S – PM x S1(1 - DPR)

M (1  POR)(S0 )
S0 
A0 *  L0 *  M (1  POR)(S0 )

$0 = (0.75) ∆S – (0.15)∆S - 0.05 x S1 (1 - 0.6)

$0 = (0.75 ) ∆S - (0.15)∆S - (0.02)S1
$0 = (0.6)∆S - (0.02)S1
$0 = 0.6(S1 - S0) - (0.02)S1
$0 = 0.6(S1 - $2,000,000) - (0.02)S1
$0 = 0.6S1 - $1,200,000 - 0.02S1
$1,200,000 = 0.58S1
$1,200,000/0.58 = 0.58/0.58s1
$2,068,965.52 = S1.

Therefore, a company can achieve sales increment of ∆S = S1 - S0

= $2,068,965.52 – $2,000,000
= $68,965.52 without raising additional funds externally.

Problem 6-11, pg. 224

REGRESSION AND INVENTORIES. Charlie’s Cycles Inc. has $110
million in sales. The company expects that its sales will increase 5% this
year.Charlie’s CFO uses a simple linear regression to forecast the company’s
inventory level for a given level of projected sales. On the basis of recent
history, the estimated relationship between inventories and sales (in millions of
dollars) is as follows:
Inventories = $9 + 0.0875 (Sales)
Given the estimated sales forecast and the estimated relationship between
inventories and sales, what are your forecasts of the company’s year-end
inventory level and inventory turnover ratio?

Sales without 5% increase: Sales with 5% increase:

Sales = $110 million Sales = $110 million x 1.05
=$115.5 million
Inventories = $9 + 0.0875 ($110
million) Inventories = $9 + 0.0875 ($115.5
= $18.625 million million)
= $19.10625 million
Inventory Turnover =
Sales/Inventories Inventory Turnover =
=$110 million / $18.625 million Sales/Inventories
=5.91 times =$115.5 million / $19.10625 million
=6.05 times

Problem 6-11, pg. 224

ADDITIONAL FUNDS NEEDED. Morissey Technologies Inc.’s 2015 financial
statements are shown here:
Morrissey Technologies Inc.: Balance Sheet as of December 31, 2015

Cash $180,000 Accounts payable $360,000

Receivables 360,000 Notes payable 56,000

Inventories 720,000 Accrued liabilities 180,000

Total current assets $1,260,000 Total current liabilities $596,000

Long-term debt 100,000

Fixed assets 1,440,000 Common stock 1,800,000

Retained earnings 204,000

Total assets $2,700,000 Total liabilities and equity $2,700,000

Morrissey Technologies Inc.: Income Statement for December 31, 2015

Sales $3,600,000

Operating costs including depreciation 3,279,720

EBIT $320,280

Interest 20,280

EBT $300,000

Taxes (40%) 120,000

Net Income $180,000

Per Share Data:

Common stock price $45.00

Earnings per share (EPS) $1.80

Dividends per share (DPS) $1.08

Suppose that in 2016, sales increase by 15% over 2012 sales. The firm
currently has 100,000 shares outstanding. It expects to maintain its 2015
dividend payout ratio and believes that its assets should grow at the same rate
as sales. The firm has no excess capacity. However, the firm would like to
reduce its Operating costs/Sales ratio to 89.5% and increase its total
debt-to-assets ratio to 30%. (It believes that its current debt ratio is too low
relative to the industry average.) The firm will raise 30% of 2013 forecasted
total debt as notes payable, and it will issue long-term bonds for the remainder.
The firm forecasts that its before-tax cost of debt (which includes both
short-term and long-term debt) is 12%. Assume that any common stock
issuances or repurchases can be made at the firm's current stock price of $45.

a. Construct the forecasted financial statements assuming that these changes

are made. What are the firm's forecasted notes payable and long-term debt
balances? What is the forecasted addition to retained earnings?
b. If the profit margin remains at 5% and the dividend payout ratio remains at
60%, at what growth rate in sales will the additional financing
requirements be exactly zero? In otherwords, what is the firm's sustainable
growth rate? (Hint: Set AFN equal to zero and solve for g.) Round your
answer to two decimal places.
%

Solution:
a.
Morrissey Technologies Inc.
Pro Forma Income Statement
December 31, 2016

Forecast 2016
2015 Basis Pro Forma
Sales $3,600,000 1.10 $3,960,000
Operating Costs 3,279,720 0.9110 3,607,692
EBIT $ 320,280 $ 352,308
Interest 20,280 20,280
EBT $ 300,000 $ 332,028
Taxes (40%) 120,000 132,811
Net income $ 180,000 $ 199,217

Dividends: $1.08  100,000 = $ 108,000 $ 112,000*

Addition to RE: $ 72,000 $
87,217

*2015 Dividends = $1.12  100,000 = $112,000.

 Morrissey Technologies Inc.
Pro Forma Balance Statement
December 31, 2016

Forecast
Basis 

2016
2015 2016 Sales Additions
Pro Forma

It was assumed that additional fund needed is financed by short-term

bank loan, that is reflected in Notes Payable. Forcasted financial statements:
Additional fund needed (AFN) through notes payable
= New notes payable - old notes payable
= $284,783 - $156,000 = $128,783.
The required Notes Payable is $284,783 and the required Additional
Fund Needed (AFN) for the company is $128,783.

Also, the required Notes Payable = $284,783.

b. AFN = $2,700,000/$3,600,000(Sales)
- ($360,000 + $180,000)/$3,600,000(Sales)
- (0.05)($3,600,000 + Sales)0.4
$0 = 0.75(Sales) - 0.15(Sales) - 0.02(Sales) - $72,000
$0 = 0.58(Sales) - $72,000
$72,000 = 0.58(Sales)
Sales = $124,138.

Growth rate in sales:

  Sales $124,138
= = 3.45%.
$3,600,000 $3,600,000
Growth Rate in Sales = 3.45%