Your company, Martin Industries, Inc., has experienced a higher than expected demand for its new product line. The company plans to expand its operation by 25% by spending $5,000,000 for an additional building.
The firm would like to maintain its 40% debt to total asset ratio in its capital structure and its dividend payout ratio of 50% of net income. Last year, net income was $2,500,000.
Required:
1. What are retained earnings for last year?
2. How much debt will be needed for the new project?
3. How much external equity must Martin use at the beginning of this year in order to finance the new expansion?
4. If Martin decides to retain all earnings for the coming year, how much external equity will be required?
The first question I got, but I don't know how to figure out the remaining 3 questions. Is there a formula I need to use?
To answer the remaining three questions, you need to understand some concepts related to capital structure and financing.
1. To calculate retained earnings for last year, you simply multiply the net income by the dividend payout ratio. In this case, the net income was $2,500,000, and the dividend payout ratio is 50%, so the retained earnings can be calculated as follows:
Retained Earnings = Net Income * Dividend Payout Ratio
Retained Earnings = $2,500,000 * 0.50
Retained Earnings = $1,250,000
2. To determine the amount of debt needed for the new project, you need to use the target debt to total asset ratio of 40%. The formula to calculate the debt needed is:
Debt Needed = Total Assets * Debt to Total Asset Ratio
Debt Needed = $5,000,000 (additional building) / (1 - 0.40)
Using this formula, you can calculate the debt needed for the new project.
3. To determine the amount of external equity needed at the beginning of the year to finance the new expansion, you need to use the formula:
External Equity Needed = Total Assets - Debt - Retained Earnings
Here, you can substitute the values for total assets, debt, and retained earnings to find the external equity required.
4. If Martin decides to retain all earnings for the coming year, the additional external equity required can be calculated using the same formula as above:
External Equity Required = Debt Needed - Retained Earnings
Again, you would substitute the values you have calculated for debt needed and retained earnings to get the external equity required.
Note that the specific numbers and calculations will depend on the provided information, such as the target debt to total asset ratio and the retained earnings. Adjustments may need to be made based on the specific context of the problem.