978-1260153590 Chapter 4 Solutions Manual Part 1

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CHAPTER 4

LONG-TERM FINANCIAL PLANNING

AND GROWTH

Answers to Concepts Review and Critical Thinking Questions

1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets,

2. Two assumptions of the sustainable growth formula are that the company does not want to sell new

equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt-

3. The internal growth rate is greater than 15 percent, because at a 15 percent growth rate the negative

EFN indicates that there is excess internal financing. If the internal growth rate is greater than 15

4. The sustainable growth rate is greater than 20 percent, because at a 20 percent growth rate the

negative EFN indicates that there is excess financing still available. If the firm is 100 percent equity

financed, then the sustainable and internal growth rates are equal and the internal growth rate would

5. Presumably not, but, of course, if the product had been much less popular, then a similar fate would

6. Since customers did not pay until shipment, receivables rose. The firm’s NWC, but not its cash,

CHAPTER 4 – 2

7. Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the

8. Financing possibly could have been arranged if the company had taken quick enough action.

9. All three were important, but the lack of cash or, more generally, financial resources ultimately

10. Demanding cash up front, increasing prices, subcontracting production, and improving financial

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this

solutions manual, rounding may appear to have occurred. However, the final answer for each problem is

found without rounding during any step in the problem.

Basic

1. It is important to remember that equity will not increase by the same percentage as the other assets.

If every other item on the income statement and balance sheet increases by 15 percent, the pro forma

income statement and balance sheet will look like this:

Pro forma income statement Pro forma balance sheet

Sales $ 43,700 Assets $31,395 Debt $ 7,705

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity – Debt

Equity increased by:

CHAPTER 4 – 3

Net income is $6,210 but equity only increased by $3,090; therefore, a dividend of:

must have been paid. Dividends paid is the plug variable.

2. Here we are given the dividend amount, so dividends paid is not a plug variable. If the company

pays out one-half of its net income as dividends, the pro forma income statement and balance sheet

will look like this:

Pro forma income statement Pro forma balance sheet

Sales $43,700 Assets $31,395 Debt $ 6,700

Note that the balance sheet does not balance. This is due to EFN. The EFN for this company is:

EFN = Total assets – Total liabilities and equity

3. An increase of sales to $8,424 is an increase of:

Assuming costs and assets increase proportionally, the pro forma financial statements will look like

this:

Pro forma income statement Pro forma balance sheet

Sales $ 8,424.00 Assets $25,389.00 Debt $ 9,100.00

If no dividends are paid, the equity account will increase by the net income, so:

So the EFN is:

EFN = Total assets – Total liabilities and equity

CHAPTER 4 – 4

4. An increase of sales to $29,210 is an increase of:

Assuming costs and assets increase proportionally, the pro forma financial statements will look like

this:

Pro forma income statement Pro forma balance sheet

Sales $29,210.00 Assets $ 70,150 Debt $ 26,900

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times

net income, or:

The addition to retained earnings is:

And the new equity balance is:

So the EFN is:

EFN = Total assets – Total liabilities and equity

5. Assuming costs, current liabilities, and assets increase proportionally, the pro forma financial

statements will look like this:

Pro forma income statement Pro forma balance sheet

Sales $9,085.00 CA $4,485.00 CL $2,415.00

CHAPTER 4 – 5

The payout ratio is 40 percent, so dividends will be:

The addition to retained earnings is:

So the EFN is:

EFN = Total assets – Total liabilities and equity

6. To calculate the internal growth rate, we first need to calculate the ROA, which is:

ROA = NI/TA

The plowback ratio, b, is one minus the payout ratio, so:

Now we can use the internal growth rate equation to get:

Internal growth rate = (ROA × b)/[1 – (ROA × b)]

7. To calculate the sustainable growth rate, we first need to calculate the ROE, which is:

ROE = NI/TE

The plowback ratio, b, is one minus the payout ratio, so:

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

CHAPTER 4 – 6

8. The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable

growth rate, we first need to calculate the ROE, which is:

ROE = NI/TE

The plowback ratio, b, is one minus the payout ratio, so:

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

So, the maximum dollar increase in sales is:

9. Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement

will look like this:

HEIR JORDAN CORPORATION

Pro Forma Income Statement

Sales $58,800

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times

net income, or:

And the addition to retained earnings will be:

CHAPTER 4 – 7

10. Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes

payable, total current liabilities, long-term debt, and all equity accounts do not vary directly with

sales.

HEIR JORDAN CORPORATION

Balance Sheet

($) (%) ($) (%)

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 2,950 6.02 Accounts payable $ 2,400 4.90

Accounts receivable 4,100 8.37 Notes payable 5,400 n/a

11. Assuming costs vary with sales and a 15 percent increase in sales, the pro forma income statement

will look like this:

HEIR JORDAN CORPORATION

Pro Forma Income Statement

Sales $56,350.00

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times

net income, or:

And the addition to retained earnings will be:

The new accumulated retained earnings on the pro forma balance sheet will be:

CHAPTER 4 – 8

The pro forma balance sheet will look like this:

HEIR JORDAN CORPORATION

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 3,392.50 Accounts payable $ 2,760.00

So the EFN is:

EFN = Total assets – Total liabilities and equity

12. We need to calculate the retention ratio to calculate the internal growth rate. The retention ratio is:

b = 1 – .25

b = .75

Now we can use the internal growth rate equation to get:

Internal growth rate = (ROA × b)/[1 – (ROA × b)]

13. We need to calculate the retention ratio to calculate the sustainable growth rate. The retention ratio

is:

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

CHAPTER 4 – 9

14. We first must calculate the ROE to calculate the sustainable growth rate. To do this we must realize

two other relationships. The total asset turnover is the inverse of the capital intensity ratio, and the

equity multiplier is 1 + D/E. Using these relationships, we get:

ROE = (PM)(TAT)(EM)

The plowback ratio is one minus the dividend payout ratio, so:

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

15. We must first calculate the ROE using the DuPont ratio to calculate the sustainable growth rate. The

ROE is:

ROE = (PM)(TAT)(EM)

The plowback ratio is one minus the dividend payout ratio, so:

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

Intermediate

16. To determine full capacity sales, we divide the current sales by the capacity the company is currently

using, so:

The maximum sales growth is the full capacity sales divided by the current sales, so:

CHAPTER 4 – 10

17. To find the new level of fixed assets, we need to find the current percentage of fixed assets to full

capacity sales. Doing so, we find:

Next, we calculate the total dollar amount of fixed assets needed at the new sales figure.

The new fixed assets necessary is the total fixed assets at the new sales figure minus the current level

of fixed assts.

18. We have all the variables to calculate ROE using the DuPont identity except the profit margin. If we

find ROE, we can solve the DuPont identity for profit margin. We can calculate ROE from the

sustainable growth rate equation. For this equation we need the retention ratio, so:

Using the sustainable growth rate equation and solving for ROE, we get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

Now we can use the DuPont identity to find the profit margin as:

ROE = PM(TAT)(EM)