I need some help with an assignment that I am working on for Introduction to Finance class. Here is the questions:
The Landis Corporation had 2008 sales of $100 million. The balance sheet items that
vary directly with sales and the profit margin are as follows:
Percent
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5%
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . 15
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Net fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . 40
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . 15
Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Profit margin after taxes . . . . . . . . . . . . . . . . . . 6%
The dividend payout rate is 50 percent of earnings, and the balance in retained earnings at the end of 2008 was $33 million. Common stock and the company’s long-term bonds are constant at $10 million and $5 million, respectively. Notes payable are currently $12 million.
a. How much additional external capital will be required for next year if sales increase 15 percent? (Assume that the company is already operating at full capacity.)
b. What will happen to external fund requirements if Landis Corporation reduces the payout ratio, grows at a slower rate, or suffers a decline in its profit margin? Discuss each of these separately.
c. Prepare a pro forma balance sheet for 2009 assuming that any external funds being acquired will be in the form of notes payable. Disregard the information in part b in answering this question (that is, use the original information and part a in constructing your pro forma balance sheet).
Here is what I have so far but I am not sure if I am doing it right. Now I have to do the pro forma balance sheet and am totally lost. Please help!!
a. How much additional external capital will be required for next year if sales increase 15 percent? (Assume that the company is already operating at full capacity.)
1. 100,000,000 x 15% = 100 million x .15 = 15,000,000 in increased sales.
2. 85%(15,000,000) – 25%(15,000,000) – 6%(115,000,000) x (1 – 50%) =
.85(15,000,000) - .25(15,000,000) - .06(115,000,000) x .50 =
12,750,000 – 3,750,000 – [6,900,000(.50)] =
12,750,000 – 3,750,000 – 3,450,000 = $5,550,000
Therefore, $5,500,000 is the outside funding required.
b. What will happen to external fund requirements if Landis Corporation reduces the payout ratio, grows at a slower rate, or suffers a decline in its profit margin? Discuss each of these separately.
1. If the dividend ratio is decreased to 25% instead of 50%, then the required amount of outside funding is decreased as shown below. The amount of outside funding required is decreased due to the increase in the amount of revenue retained in the company to reinvest in the company.
85%(15,000,000) – 25%(15,000,000) – 6%(115,000,000) x (1 – 25%)
.85(15,000,000) - .25(15,000,000) - .06(115,000,000) x .75
12,750,000 – 3,750,000 – [6,900,000(.75)]
12,750,000 – 3,750,000 – 5,175,000 = 3,825,000
2. If the company’s growth is slowed to 10% rather than 15%, there is a decrease in required funding. Since the company is growing at a slower rate, less capital is needed to fund the slower growth. An example is shown below.
a. 100,000,000 x .10 = 10,000,000
b. .85(10,000,000) - .25(10,000,000) - .06(110,000,000) x .50 =
8,500,000 – 2,500,000 – [6,600,000(.50)] =
12,750,000 – 3,750,000 – 3,300,000 = $2,700,000
3. A decline in the profit margin will result in an increase in the required outside funding. This is due to the decrease in profits that are used to reinvest in the company. An example is shown below.
85%(15,000,000) – 25%(15,000,000) – 3%(115,000,000) x (1 – 50%) =
.85(15,000,000) - .25(15,000,000) - .03(115,000,000) x .50 =
12,750,000 – 3,750,000 – [3,450,000(.50)] =
12,750,000 – 3,750,000 – 1,725,000 = $7,275,000
recheck your answers to part b
To calculate the additional external capital required for next year if sales increase 15 percent, you need to follow these steps:
1. Calculate the increase in sales: Multiply the current sales ($100 million) by the percentage increase (15%): 100 million x 0.15 = $15 million.
2. Determine the additional balance sheet items that will vary with the increase in sales:
- Cash: 5% of the increase in sales = 0.05 x $15 million = $750,000.
- Accounts receivable: 15% of the increase in sales = 0.15 x $15 million = $2.25 million.
- Inventory: 25% of the increase in sales = 0.25 x $15 million = $3.75 million.
3. Calculate the increase in total assets: Add the additional amounts of cash, accounts receivable, and inventory to the current total assets. Since Landis Corporation is operating at full capacity, the increase in sales will require an increase in current assets to support the higher level of production:
- Current assets = current sales x (cash + accounts receivable + inventory + accruals)
= $100 million x (0.05 + 0.15 + 0.25 + 0.10) = $55 million.
- Additional current assets = additional cash + additional accounts receivable + additional inventory
= $750,000 + $2.25 million + $3.75 million = $6.75 million.
- Total assets = current assets + additional current assets
= $55 million + $6.75 million = $61.75 million.
4. Calculate the additional external financing required: Subtract the increase in total assets from the increase in retained earnings and notes payable to determine the additional external financing required:
- Increase in retained earnings = (increase in sales - total assets) x profit margin after taxes
= ($15 million - $61.75 million) x 0.06 = -$2.345 million (negative value indicates a decrease in retained earnings).
- External financing required = increase in retained earnings + increase in notes payable
= -$2.345 million + ($2.7 million) = $354,000 (additional external financing required).
Therefore, if sales increase 15 percent, an additional external capital of $354,000 will be required.
For the pro forma balance sheet for 2009, assuming any external funds being acquired will be in the form of notes payable, you need to update the balance sheet based on the new sales and additional external financing required.
Landis Corporation Pro Forma Balance Sheet for 2009:
2008 Pro Forma Balance Sheet
Assets:
Current assets:
Cash $5 million $5 million + $750,000 (additional cash)
Accounts receivable $15 million $15 million + $2.25 million (additional accounts receivable)
Inventory $25 million $25 million + $3.75 million (additional inventory)
Total current assets $55 million $55 million + $6.75 million (additional current assets)
Net fixed assets $40 million $40 million (no change)
Total assets $95 million $101.75 million (increase in current assets)
Liabilities and Shareholders' Equity:
Accounts payable $4 million $4 million (no change)
Accruals $6 million $6 million (no change)
Notes payable $12 million $12 million + $354,000 (additional notes payable)
Total current liabilities $22 million $22.354 million (increase in notes payable)
Long-term bonds $5 million $5 million (no change)
Total liabilities $27 million $27.354 million (increase in notes payable)
Common stock $10 million $10 million (no change)
Retained earnings $33 million $33 million - $2.345 million (reduction in retained earnings)
Total shareholders' equity $43 million $45.655 million (decrease in retained earnings)
Total liabilities and shareholders' equity $95 million $101.75 million (increase in current assets)
Please note that the pro forma balance sheet assumes no changes in common stock and long-term bonds, and the additional external financing is in the form of notes payable.