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).
Explain the importance of understanding inventory valuation methods in dertermining the quality of the profit
To calculate the additional external capital required for next year, we need to determine the change in balance sheet items that are directly related to sales. The formula to calculate the additional external capital required is:
Additional External Capital = (Change in Assets - Change in Liabilities - Change in Retained Earnings - Change in Notes Payable) * (1 - Dividend Payout Ratio)
Let's calculate each component separately:
a. Change in Assets:
The assets that vary directly with sales are accounts receivable, inventory, and net fixed assets. Since the company is already operating at full capacity, net fixed assets will not change. Therefore, the change in assets is equal to the change in accounts receivable and inventory.
Change in Accounts Receivable = Sales Growth Rate * Accounts Receivable Percentage
Change in Accounts Receivable = 15% * $100 million = $15 million
Change in Inventory = Sales Growth Rate * Inventory Percentage
Change in Inventory = 25% * $100 million = $25 million
Total Change in Assets = Change in Accounts Receivable + Change in Inventory
Total Change in Assets = $15 million + $25 million = $40 million
b. Change in Liabilities:
The liabilities that vary directly with sales are accounts payable and accruals.
Change in Accounts Payable = Sales Growth Rate * Accounts Payable Percentage
Change in Accounts Payable = 15% * $100 million = $15 million
Change in Accruals = Sales Growth Rate * Accruals Percentage
Change in Accruals = 10% * $100 million = $10 million
Total Change in Liabilities = Change in Accounts Payable + Change in Accruals
Total Change in Liabilities = $15 million + $10 million = $25 million
c. Change in Retained Earnings:
The change in retained earnings is calculated based on the profit margin after taxes and the dividend payout rate.
Change in Retained Earnings = (Sales Growth Rate * Profit Margin) * (1 - Dividend Payout Ratio)
Change in Retained Earnings = (15% * $100 million * 6%) * (1 - 50%)
Change in Retained Earnings = $0.9 million
d. Change in Notes Payable:
The change in notes payable can be calculated as the difference between the new total liabilities and the sum of the old total liabilities and the change in accounts payable and accruals.
Change in Notes Payable = (New Total Liabilities) - (Old Total Liabilities) - (Change in Accounts Payable) - (Change in Accruals)
Change in Notes Payable = $0
e. Additional External Capital Required:
Now, we can plug in the values into the formula to calculate the additional external capital required.
Additional External Capital = (Change in Assets - Change in Liabilities - Change in Retained Earnings - Change in Notes Payable) * (1 - Dividend Payout Ratio)
Additional External Capital = ($40 million - $25 million - $0.9 million - $0) * (1 - 50%)
Additional External Capital = $14.1 million
Therefore, the Landis Corporation will require an additional $14.1 million of external capital for next year if sales increase by 15%.
To answer the other parts of the question (b and c), we need more information on how reducing the payout ratio, growing at a slower rate, or declining profit margin will affect the balance sheet items and the dividend payout ratio. Once that information is provided, we can further analyze and discuss the impact on external fund requirements and prepare a pro forma balance sheet for 2009.