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:
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 one place that might help you:
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CP 4-1. Continued
CP Solution:
Landis Corporation
b. If Landis reduces the payout ratio, the company will retain more earnings and need less external funds. A slower growth rate means that less assets will have to be financed and in this case, less external funds would be needed. A declining profit margin will lower retained earnings and force Landis Corporation to seek more external funds.
CP 4-1. Continued
c.
Balance Sheet—December 31, 2005
(Dollars in Millions)
Cash $ 5.75 Accounts Payable $17.25
Accounts Receivable 17.25 Accruals 11.50
Inventory 28.75 Notes Payable 17.551
Net Fixed Assets 46.00 Long-Term Bonds 5.00
Common Stock 10.00
_____ Retained Earnings 36.452
$97.75 $97.75
1Original notes payable plus required new funds. This is the plug figure.
22005 retained earnings (beginning of 2005) + PS2 (1-.D) or $33 mil + $3.45 mil
a. To calculate the additional external capital required for next year, we need to determine the increase in sales and the corresponding increase in the balance sheet items that vary directly with sales.
1. Calculate the increase in sales:
Sales increase = 15% of $100 million = $15 million
2. Calculate the increase in the balance sheet items:
Cash increase = 5% of $15 million = $0.75 million
Accounts receivable increase = 15% of $15 million = $2.25 million
Inventory increase = 25% of $15 million = $3.75 million
3. Calculate the total increase in current assets:
Total current assets increase = Cash increase + Accounts receivable increase + Inventory increase
Total current assets increase = $0.75 million + $2.25 million + $3.75 million = $6.75 million
4. Calculate the increase in total assets:
Total assets increase = Total current assets increase + Net fixed assets (constant)
Total assets increase = $6.75 million + $0 (net fixed assets are constant) = $6.75 million
5. Determine the additional external capital required:
Additional external capital required = Total assets increase
Additional external capital required = $6.75 million
Therefore, if sales increase by 15 percent, the Landis Corporation will require an additional $6.75 million of external capital for next year.
b. The external fund requirements will be affected by changes in the payout ratio, growth rate, and profit margin as follows:
i. Reduced payout ratio: If the dividend payout ratio is reduced, the retained earnings will increase, resulting in a higher internal source of funds. This will reduce the external fund requirements.
ii. Slower growth rate: If the company grows at a slower rate, the increase in sales and the related balance sheet items will be lower. As a result, the external fund requirements will be lower.
iii. Decline in profit margin: A decline in profit margin will reduce the net income, leading to a lower retained earnings. This will increase the external fund requirements.
c. To prepare the pro forma balance sheet for 2009, assuming that any external funds being acquired will be in the form of notes payable, we need to calculate the changes in each balance sheet item.
1. Calculate the changes in balance sheet items:
Cash change = 5% of the expected sales increase
Accounts receivable change = 15% of the expected sales increase
Inventory change = 25% of the expected sales increase
Net fixed assets = Constant (mentioned in the question)
Accounts payable = 15% of the expected sales increase
Accruals = 10% of the expected sales increase
Notes payable = Increase in external capital required (calculated in part a)
2. Calculate the new values for each balance sheet item:
Cash = Old value + Cash change
Accounts receivable = Old value + Accounts receivable change
Inventory = Old value + Inventory change
Net fixed assets = Constant (mentioned in the question)
Accounts payable = Old value + Accounts payable change
Accruals = Old value + Accruals change
Notes payable = Old value + New external capital required (calculated in part a)
Retained earnings = Old value + Net income - Dividends
3. Construct the pro forma balance sheet by listing the new values for each balance sheet item.
Note: Since the question does not provide specific values for each balance sheet item, you will need to use the given percentages and assumptions to calculate the changes and construct the pro forma balance sheet.