Business 2019

Assignment 2
Solutions

1. Consider the balance sheets and income statements for Sunrise, Inc. depicted in Table
1 and Table 2.

(a) For year 2000, calculate Sunrise’s cash flow from assets, the cash flow to creditors
and the cash flow to shareholders.
Answer: Sunrise’s operating cash flow (OCF) is given by

OCF = Net income + Interest + Depreciation

= $1, 105 + $500 + $350

= $1, 955.

Net capital spending (NCS) is given by

NCS = NFA2000 − NFA1999 + Depreciation

= $10, 230 − $10, 007 + $350

= $573,

where NFAx denotes Net fixed assets at the end of year x. Change in net working
capital, ∆NWC, is given by

∆NWC = NWC2000 − NWC1999

= $6, 228 − $1, 337 − $5, 502 − $1, 290

= $679.

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 Hence cash flow from assets, CF(A), is

CF(A) = OCF − NCS − ∆NWC = $1, 955 − $573 − $679 = $703.

Cash flow to shareholders, CF(S), is

CF(S) = Dividends + Net shares repurchases

= $474 + (−$300)

= $174.

Cash flow to bondholders, CF(B), is

CF(B) = Interest + Net debt redeemed

= $500 + $29

= $529.

To check if these answers are right,

CF(S) + CF(B) = $174 + $529 = $703 = CF(A).

(b) Prepare Sunrise’s 2000 statement of change in financial position. What were the
main uses of cash in 2000?
Answer: The statement of change in financial position is depicted in Table 3.
The main uses of cash in 2000 were, in descending order, the increase in inventory
($1,330), net capital spending ($573), dividends paid ($474) and the increase in
accounts receivable ($420).

(c) Prepare the common-size balance sheets for Sunrise in 1999 and 2000. What ob-
servations can you make from these balance sheets?
Answer: Refer to Table 4 for the common-size balance sheets. Form these state-
ments, we see a substantial decline in cash as a fraction of total assets and a
substantial increase in inventory.

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(d) Prepare the common-size income statements for Sunrise in 1999 and 2000. What
observations can you make from these income statements?
Answer: Refer to Table 5 for the common-size income statements. There is no
significant change from 1999 to 2000.

(e) Calculate, for both 1999 and 2000, Sunrise’s (i) current ratio, (ii) quick ratio and
(iii) cash ratio. What can you say from these ratios?
5,502 6,228
Answer: The current ratio was 1,290
= 4.27 in 1999 and 1,337
= 4.67 in 2000.
5,502−2,200 6,228−3,530
The quick ratio was 1,290
= 2.56 in 1999 and 1,337
= 2.02 in 2000. The
2,099 1,075
cash ratio was 1,290
= 1.63 in 1999 and 1,337
= 0.80 in 2000. Even though the
current ratio is higher in 2000 than in 1999, Sunrise’s short-term solvency seems
to be declining.

(f) Calculate, for both 1999 and 2000, Sunrise’s (i) total debt ratio, (ii) debt/equity
ratio, (iii) equity multiplier and (iv) long-term debt ratio. What can you say from
these ratios?
1,290+5,118 1,337+5,089
Answer: The total debt ratio was 15,509
= 0.41 in 1999 and 16,458
= 0.39
1,290+5,118 1,337+5,089
in 2000. The debt/equity ratio was 9,109
= 0.70 in 1999 and 10,032
= 0.64
15,509 16,458
in 2000. The equity multiplier was 9,109
= 1.70 in 1999 and 10,032
= 1.64 in 2000.
5,118 5,089
The long-term debt ratio was 5,118+9,109
= 0.36 in 1999 and 5,089+10,032
= 0.34 in
2000. These ratios are not significantly different between the two years.

(g) Calculate, for both 1999 and 2000, Sunrise’s (i) inventory turnover ratio, (ii)
days’ sales in inventory and (iii) asset turnover ratio. What can you say from
these ratios?
3,600 3,900
Answer: Inventory turnover ratio was 2,200
= 1.64 times in 1999 and 3,530
= 1.10
365
times in 2000. Hence the days’ sales in inventory was 1.64
= 222.56 days in 1999
365 7,000
and 1.10
= 331.82 days in 2000. Total asset turnover ratio was 15,509
= 0.45 times
7,700
in 1999 and 16,458
= 0.47 times in 2000. We observe a significant increase in in
days’ sales in inventory.

(h) Calculate, for both 1999 and 2000, Sunrise’s (i) profit margin, (ii) return on assets

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 and (iii) return on equity. Derive the Du Pont identity for both years.
1,040 1,105
Answer: The profit margin was 7,000
= 14.9% in 1999 and 7,500
= 14.6% in 2000.
1,040 1,105
The return on assets was 15,509
= 6.7% in 1999 and 16,458
= 6.7% in 2000. The
1,040 1,105
return on equity was 9,101
= 11.4% in 1999 and 10,032
= 11.0% in 2000. The Du
Pont identity is

ROE = Profit margin × Total asset turnover × Equity multiplier

= 14.9% × 45% × 1.7 in 1999

= 14.6% × 47% × 1.64 in 2000.

Hence the decline in the return on equity from 1999 to 2000 is attributable to the
decline in profit margin and the decline in the equity multiplier.

2. The most recent financial statements for Rosegarten Corporation are shown in Table 6
and Table 7. Sales for 2001 are projected to grow by 25 percent. The tax rate and the
dividend payout rate will remain constant. Costs, current assets and accounts payable
increase in proportions with sales.

(a) If the firm is operating at full capacity and no new debt or equity is issued, what
is the external financing needed to support the 25 percent growth rate?
Answer: When sales grow at the rate g, the increase in total assets (A) is
Ag. On the right-hand side of the balance sheet, retained earnings increase by
(1+g)pSR, where p denotes the profit margin, S denotes total sales and R denotes
the retention ratio. Also, accounts payable (A/P) increase in proportions with S,
i.e. the increase in A/P is (A/P)g. Hence if no new debt or equity is issued, the
external financing needed to support a growth rate g is given by

EFN = Ag − (1 + g)pSR − (A/P)g.

264 176 2
Here we have A = 3, 000, p = 2000
= 13.2%, S = 2, 000, R = 264
= 3
and

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 A/P = 300. This gives us

2
EFN = 3, 000g − (1 + g) × .132 × 2, 000 × − 300g
3
= 3, 000g − (1 + g)176 − 300g

= −176 + 2, 524g.

Hence if g = 25%, EFN is equal to $455.

(b) Suppose now that the firm was operating at only 80 percent capacity in 2000.
What is EFN now?
Answer: If the firm was operating at 80 percent of capacity in 2000, $1,800 of
2,000
net fixed assets can support up to .8
= $2, 500 of sales. Hence there is no need
for additional fixed assets if sales grow by 25%. Current assets will nevertheless
grow with sales, and thus the increase in total assets is 1, 200 × 25% = 300. The
changes in the right-hand side of the balance sheet are as in (a), i.e. it increases
by $295. Hence the external financing needed in this case is 300 − 295 = $5.

(c) Assume the firm is operating at full capacity. If it wishes to keep a current ratio
of at least 3 and a total debt ratio of at most 0.4, what is a possible financing
plan?
Answer: Projected current assets are $1,500 and projected accounts payable are
$375. Maintaining a current ratio of at least 3 means that

1, 500
≥ 3 ⇒ A/P ≤ 125.
375 + A/P

That is, notes payable can increase by at most $25.

Suppose projected current liabilities are then $500. To maintain a total debt ratio
of at most 0.4 when projected total assets are $3,750 means that

500 + LTD
≤ 0.4 ⇒ LTD ≤ $1, 000.
3, 750

Therefore, LTD can increase by at most $200.

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 So far, we have found $25 + $200 = $225, but we need $455. The amount missing,
which is 455 − 225 = $230, will be obtained by raising equity. Hence a possible
financing plan is

· Increase notes payable by $25

· Increase long-term debt by $200

· Raise $230 by issuing new equity

(d) Find Rosegarten’s internal growth rate.

ROA×R
Answer: Two answers were accepted here. Either you use the formula 1−ROA×R
,
which assumes that accounts payable do not vary with sales, or you take into
account the increase in accounts payable. To find Rosegarten’s internal growth
rate in the latter case, we need to use the equation derived in (a). The growth
rate that does not require any external financing, gi is such that
176
EFN = − 176 + 2, 524gi = 0 ⇒ gi = = 6.97%.
2, 524
If you use the equation in the text, the internal growth rate obtained is
ROA × R .088 × 23
= 2 = 6.23%,
1 − ROA × R 1 − .088 × 3

which is lower than 6.97% since the increase in accounts payable allows to finance
more growth than if these were independent of sales.

(e) Find Rosegarten’s sustainable growth rate.

Answer: In this case, we can use the equation in the text since it allows debt
to increase in proportions with total equity, which will include the increase in
accounts payable. Hence Rosegarten’s sustainable growth rate is
ROE × R (264/1, 800) × 23
gs = = 2 = 10.84%.
1 − ROE × R 1 − (264/1, 800) × 3

To show that the increase in accounts payable does not create any problem, note
that retained earnings increase by 1.1084 × 176 = 195.0784, and thus total equity
195.0784
increases by 1,800
= 10.84%. Hence total debt can also increase by 10.84%,

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 which means that a total of .1084 × 1, 200 = $130.08 can be borrowed, which is
more than the $75 increase in accounts payable.

3. The most recent financial statements for AWOL Tours, Inc., are shown in Table 8 and
Table 9. Sales for 2001 are projected to grow by 20 percent. Interest expense will
remain constant; the tax rate and the dividend payout rate will also remain constant.
Costs, other expenses, current assets and accounts payable increase in proportions with
sales.

(a) If the firm is operating at full capacity and no new debt or equity is issued, what
is the external financing needed to support the 20 percent growth rate?
Answer: Since interest expense remains constant, the profit margin varies when
sales grow. Hence the equation for EFN will differ from what we have used so
far. First note that net income is equal to (1 − t) × (EBIT − I), where t is the
tax rate, EBIT denotes earnings before interest and taxes and I is the interest
expense. Since EBIT grows in proportions with sales, a sales growth rate of g
implies a projected net income of (1 − t) × ((1 + g)EBIT − I). As above, accounts
payable increase in proportions with sales, and thus the external financing needed
to support a growth rate of g is

EFN = Ag − (1 − t) × ((1 + g)EBIT − I) × R − (A/P) × g,

where A is total assets, A/P denotes accounts payable and R is the retention
ratio. This gives us (all numbers in 000’s)

EFN = 390g − .65((1 + g)140 − 17).6 − 50g = − 47.97 + 285.4g

If g = 20%, this gives us

EFN = − 47.97 + 285.4 × .2 = 9.11.

that is $9,110 is the external financing needed.

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(b) Suppose that the firm was operating at only 90 percent capacity in 2000. What
is EFN now?
$700,000
Answer: The actual net fixed assets can support .9
= $777, 777.78 is sales.
275,000
At full capacity, net fixed assets represent 777,777.78
= 35.35% of sales. Hence
1.2 × $700, 000 = $840, 000 of sales can be achieved with .3535714 × 840, 000 =
$296, 940 of fixed assets used at full capacity. The increase in total assets is then

.2 × 115, 000 + (296, 940 − 275, 000) = $44, 940.

| {z }
current assets
The changes on the right-hand side of the balance sheet are as in (a), that is

(1 − t) × ((1 + g)EBIT − I) × R + (A/P) × g = $68, 890.

Hence external financing needed in this case is

EFN = 44, 940 − 68, 890 = − $23, 950 .

(c) Assume the firm is operating at full capacity, and suppose it wishes to keep its
debt/equity ratio constant. What is EFN now?
Answer: Keeping the debt/equity ratio constant means that total debt can in-
crease by

(1 − t)((1 + g)EBIT − I)R 58, 890

× total debt = × 175, 000 = $47, 933.72 .
total equity 215, 000

Note that this is greater than the increase in accounts payable so we don’t need
to worry about this one. External financing needed is then

Ag − (1 − t)((1 + g)EBIT − I)R − 47, 933.72

= 78, 000 − 58, 890 − 47, 933.72
= − $28, 823.72 .

(d) Redo problem (a) using sales growth rates of 25 and 30 percent. Illustrate graph-
ically the relationship between EFN and the growth rate, and use this graph to

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 determine the relationship between them. At what growth rate is the EFN equal
to zero? Why is this internal growth rate different from that found by using the
equation in the text.
Answer: All we need to do here is use the equation found in (a), i.e.

EFN = − 47.97 + 285.4g .

So EFN is −47, 970 + 285, 400 × .25 = $23, 380 when the growth rate is 25%, and
EFN is −47, 970 + 285, 400 × .3 = $37, 650 when the growth rate is 30%.

The internal growth rate, gi , is such that

EFN = − 47.97 + 285.4gi = 0 ⇒ 16.8% .

Sunrise Inc.
1999 and 2000 Balance Sheets
Assets Liabilities and Owners’ Equity
2000 1999 2000 1999
Current assets Current liabilities
Cash $1,075 $2,099 Accounts payable $1,129 $1,095
Accounts receivable 1,623 1,203 Notes payable 208 195
Inventory 3,530 2,200 Total $1,337 $1,290
Total $6,228 $5,502
Long-term debt $5,089 $5,118
Fixed assets Owners’ equity
Net fixed assets $10,230 $10,007 Common stock $5,100 $4,800
Retained earnings 4,932 4,301
Total equity $10,032 $9,101
Total assets $16,458 $15,509 Total liabilities and equity $16,458 $15,509

Table 1: Balance sheets for Sunrise Inc.

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 Sunrise Inc.
Income Statements for 1999 and 2000
2000 1999
Sales $7,550 $7,000
Cost of goods sold (3,900) (3,600)
Selling expenses (1,100) (1,050)
Depreciation (350) (315)
Earnings before interest and taxes (EBIT) $2,200 $2,035
Interest (500) (435)
Taxable income $1,700 $1,600
Taxes (35%) (595) (560)
Net income $1,105 $1,040
Dividends $474 $434
Addition to retained earnings $631 $606

Table 2: Income statements for Sunrise Inc.

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 Sunrise Inc.
2000 Statement of Change in Financial Position
Operating activities
Net Income $1,105
Depreciation 350
Increase in A/P 34
Increase in A/R −420
Increase in inventory −1, 330
Net cash from operating activities −$261
Investment activities
Fixed asset acquisitions −$573
Net cash from investment activities −$573
Financing activities
Increase in notes payable $13
Decrease in long-term debt −29
Dividends paid −474
Increase in common stock 300
Net cash from financing activities −$190
Net change in cash −$1, 024

Table 3: Sunrise Inc’s statement of change in financial position.

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 Sunrise Inc.
1999 and 2000 Common-Size Balance Sheets
Assets Liabilities and Owners’ Equity
2000 1999 2000 1999
Current assets Current liabilities
Cash 6.5% 13.5% Accounts payable 6.8% 7.1%
Accounts receivable 9.9% 7.8% Notes payable 1.3% 1.3%
Inventory 21.4% 14.2% Total 8.1% 8.4%
Total 37.8% 35.5%
Long-term debt 30.9% 33.0%
Fixed assets Owners’ equity
Net fixed assets 62.2% 64.5% Common stock 31.0% 30.9%
Retained earnings 30.0% 27.7%
Total equity 61.0% 58.6%
Total assets 100% 100% Total liabilities and equity 100% 100%

Table 4: Common-size balance sheets for Sunrise Inc.

Sunrise Inc.
Common-Size Income Statements for 1999 and 2000
2000 1999
Sales 100.0% 100.0%
Cost of goods sold 51.7% 51.4%
Selling expenses 14.6% 15.0%
Depreciation 4.6% 4.5%
Earnings before interest and taxes (EBIT) 29.1% 29.1%
Interest 6.6% 6.2%
Taxable income 22.5% 22.9%
Taxes (35%) 7.9% 8.0%
Net income 14.6% 14.9%
Dividends 6.3% 6.2%
Addition to retained earnings 8.3% 8.7%

Table 5: Common-size income statements for Sunrise Inc.

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 Rosegarten Corporation
2000 Income Statement
Sales $2,000
Costs (1,600)
Taxable income $400
Taxes (34%) (136)
Net income $264
Dividends $88
Addition to retained earnings $176

Table 6: Income statement for Rosegarten Corporation.

Rosegarten Corporation
Balance Sheet as of December 31, 2000
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash $160 Accounts payable $300
Accounts receivable 440 Notes payable 100
Inventory 600 Total $400
Total $1,200
Long-term debt $800
Fixed assets Owners’ equity
Net fixed assets $1,800 Common stock $800
Retained earnings 1,000
Total equity $1,800
Total assets $3,000 Total liabilities and equity $3,000

Table 7: Balance sheet for Rosegarten Corporation.

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 AWOL Tours, Inc.
2000 Income Statement
Sales $700,000
Costs (550,000)
Other expenses (10,000)
Earnings before interest and taxes $140,000
Interest paid (17,000)
Taxable income $123,000
Taxes (35%) (43,050)
Net income $79,950
Dividends $31,980
Addition to retained earnings $47,970

Table 8: Income statement for AWOL Tours, Inc..

AWOL Tours, Inc.

Balance Sheet as of December 31, 2000
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash $20,000 Accounts payable $50,000
Accounts receivable 35,000 Notes payable 5,000
Inventory 60,000 Total $55,000
Total $115,000
Long-term debt $120,000
Fixed assets Owners’ equity
Net fixed assets $275,000 Common stock $15,000
Retained earnings 200,000
Total equity $215,000
Total assets $390,000 Total liabilities and equity $390,000

Table 9: Balance sheet for AWOL Tours, Inc..

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