4. Growth Rates. Find the sustainable and internal growth rates for a firm with the following

ratios: asset turnover = 1.40; profit margin = 5 percent; payout ratio = 25 percent; equity/as-

sets = .60.

5. Percentage of Sales Models. Percentage of sales models usually assume that costs, fixed as-

sets, and working capital all increase at the same rate as sales. When do you think that these

assumptions do not make sense? Would you feel happier using a percentage of sales model

for short-term or long-term planning?

6. Relationships among Variables. Comebaq Computers is aiming to increase its market share

by slashing the price of its new range of personal computers. Are costs and assets likely to

increase or decrease as a proportion of sales? Explain.

7. Balancing Items. What are the possible choices of balancing items when using a financial

planning model? Discuss whether some are generally preferable to others.

8. Financial Targets. Managers sometimes state a target growth rate for sales or earnings per

share. Do you think that either makes sense as a corporate goal? If not, why do you think

that managers focus on them?

9. Percentage of Sales Models. Here are the abbreviated financial statements for Planners

Practice Peanuts:

Problems INCOME STATEMENT, 2000

Sales $2,000

Cost 1,500

Net income $ 500

BALANCE SHEET, YEAR-END

1999 2000 1999 2000

Assets $2,500 $3,000 Debt $ 833 $1,000

Equity 1,667 2,000

Total $2,500 $3,000 Total $ 2,500 $3,000

If sales increase by 20 percent in 2001, and the company uses a strict percentage of sales

planning model (meaning that all items on the income and balance sheet also increase by 20

percent), what must be the balancing item? What will be its value?

10. Required External Financing. If the dividend payout ratio in problem 9 is fixed at 50 per-

cent, calculate the required total external financing for growth rates in 2001 of 15 percent,

20 percent, and 25 percent.

11. Feasible Growth Rates. What is the maximum possible growth rate for Planners Peanuts

(see problem 9) if the payout ratio remains at 50 percent and

a. no external debt or equity is to be issued

b. the firm maintains a fixed debt ratio but issues no equity

Financial Planning 103

12. Using Percentage of Sales. Eagle Sports Supply has the following financial statements. As-

sume that Eagle™s assets are proportional to its sales.

INCOME STATEMENT, 2000

Sales $ 950

Costs 250

EBIT 700

Taxes 200

Net income $ 500

BALANCE SHEET, YEAR-END

1999 2000 1999 2000

Assets $2,700 $3,000 Debt $ 900 $1,000

Equity 1,800 2,000

Total $2,700 $3,000 Total $ 2,700 $3,000

a. Find Eagle™s required external funds if it maintains a dividend payout ratio of 60 percent

and plans a growth rate of 15 percent in 2001.

b. If Eagle chooses not to issue new shares of stock, what variable must be the balancing

item? What will its value be?

c. Now suppose that the firm plans instead to increase long-term debt only to $1,100 and

does not wish to issue any new shares of stock. Why must the dividend payment now be

the balancing item? What will its value be?

13. Feasible Growth Rates.

a. What is the internal growth rate of Eagle Sports (see problem 12) if the dividend payout

ratio is fixed at 60 percent and the equity-to-asset ratio is fixed at 2„3?

b. What is the sustainable growth rate?

14. Building Financial Models. How would Executive Fruit™s financial model change if the

dividend payout ratio were cut to 1„3? Use the revised model to generate a new financial plan

for 2000 assuming that debt is the balancing item. Show how the financial statements given

in Table 1.16 would change. What would be required external financing?

15. Required External Financing. Executive Fruit™s financial manager believes that sales in

2000 could rise by as much as 20 percent or by as little as 5 percent.

a. Recalculate the first-stage pro forma financial statements (Table 1.15) under these two

assumptions. How does the rate of growth in revenues affect the firm™s need for external

funds?

b. Assume any required external funds will be raised by issuing long-term debt and that any

surplus funds will be used to retire such debt. Prepare the completed (second-stage) pro

forma balance sheet.

16. Building Financial Models. The following tables contain financial statements for Dynasta-

tics Corporation. Although the company has not been growing, it now plans to expand and

will increase net fixed assets (that is, assets net of depreciation) by $200,000 per year for the

next 5 years and forecasts that the ratio of revenues to total assets will remain at 1.50. An-

nual depreciation is 10 percent of net fixed assets at the start of the year. Fixed costs are ex-

pected to remain at $56,000 and variable costs at 80 percent of revenue. The company™s pol-

icy is to pay out two-thirds of net income as dividends and to maintain a book debt ratio of

25 percent of total capital.

104 SECTION ONE

a. Produce a set of financial statements for 2001. Assume that net working capital will equal

50 percent of fixed assets.

b. Now assume that the balancing item is debt, and that no equity is to be issued. Prepare a

completed pro forma balance sheet for 2001. What is the projected debt ratio for 2001?

INCOME STATEMENT, 2000

(figures in thousands of dollars)

Revenue $1,800

Fixed costs 56

Variable costs (80% of revenue) 1,440

Depreciation 80

Interest (8% of beginning-of-year debt) 24

Taxable income 200

Taxes (at 40%) 80

Net income $ 120

Dividends $80

Retained earnings $40

BALANCE SHEET, YEAR-END

(figures in thousands of dollars)

1999 2000

Assets

Net working capital $ 400 $ 400

Fixed assets 800 800

Total assets $1,200 $1,200

Liabilities and shareholders™ equity

Debt $ 300 $ 300

Equity 900 900

Total liabilities and

shareholders™ equity $1,200 $1,200

17. Sustainable Growth. Plank™s Plants had net income of $2,000 on sales of $40,000 last year.

The firm paid a dividend of $500. Total assets were $100,000, of which $40,000 was fi-

nanced by debt.

a. What is the firm™s sustainable growth rate?

b. If the firm grows at its sustainable growth rate, how much debt will be issued next year?

c. What would be the maximum possible growth rate if the firm did not issue any debt next

year?

18. Sustainable Growth. A firm has decided that its optimal capital structure is 100 percent eq-

uity financed. It perceives its optimal dividend policy to be a 40 percent payout ratio. Asset

turnover is sales/assets = .8, the profit margin is 10 percent, and the firm has a target growth

rate of 5 percent.

a. Is the firm™s target growth rate consistent with its other goals?

b. If not, by how much does it need to increase asset turnover to achieve its goals?

c. How much would it need to increase the profit margin instead?

19. Internal Growth. Go Go Industries is growing at 30 percent per year. It is all-equity fi-

nanced and has total assets of $1 million. Its return on equity is 20 percent. Its plowback

ratio is 40 percent.

Financial Planning 105

a. What is the internal growth rate?

b. What is the firm™s need for external financing this year?

c. By how much would the firm increase its internal growth rate if it reduced its payout ratio

to zero?

d. By how much would such a move reduce the need for external financing? What do you

conclude about the relationship between dividend policy and requirements for external fi-

nancing?

20. Sustainable Growth. A firm™s profit margin is 10 percent and its asset turnover ratio is .5.

It has no debt, has net income of $10 per share, and pays dividends of $4 per share. What is

the sustainable growth rate?

21. Internal Growth. An all-equity“financed firm plans to grow at an annual rate of at least 10

percent. Its return on equity is 15 percent. What is the maximum possible dividend payout

rate the firm can maintain without resorting to additional equity issues?

22. Internal Growth. Suppose the firm in the previous question has a debt-equity ratio of 1„3.

What is the maximum dividend payout ratio it can maintain without resorting to any exter-

nal financing?

23. Internal Growth. A firm has an asset turnover ratio of 2.0. Its plowback ratio is 50 percent,

and it is all-equity financed. What must its profit margin be if it wishes to finance 8 percent

growth using only internally generated funds?

24. Internal Growth. If the profit margin of the firm in the previous problem is 6 percent, what

is the maximum payout ratio that will allow it to grow at 8 percent without resorting to ex-

ternal financing?

25. Internal Growth. If the profit margin of the firm in problem 23 is 6 percent, what is the

maximum possible growth rate that can be sustained without external financing?

26. Using Percentage of Sales. The 2000 financial statements for Growth Industries are pre-

sented below. Sales and costs in 2001 are projected to be 20 percent higher than in 2000.

Both current assets and accounts payable are projected to rise in proportion to sales. The

firm is currently operating at full capacity, so it plans to increase fixed assets in proportion

to sales. What external financing will be required by the firm? Interest expense in 2001 will

equal 10 percent of long-term debt outstanding at the start of the year. The firm will main-

tain a dividend payout ratio of .40.

INCOME STATEMENT, 2000

Sales $ 200,000

Costs 150,000

EBIT 50,000

Interest expense 10,000

Taxable income 40,000

Taxes (at 35%) 14,000

Net income $ 26,000

Dividends 10,400

Retained earnings 15,600

106 SECTION ONE

BALANCE SHEET, YEAR-END, 2000

Assets Liabilities

Current assets Current liabilities

Cash $ 3,000 Accounts payable $ 10,000

Accounts receivable 8,000 Total current liabilities 10,000

Inventories 29,000 Long-term debt 100,000

Total current assets $ 40,000 Stockholders™ equity

Net plant and equipment 160,000 Common stock plus

additional paid-in capital 15,000

Retained earnings 75,000

Total liabilities plus

Total assets $ 200,000 stockholders™ equity $ 200,000

27. Capacity Use and External Financing. Now suppose that the fixed assets of Growth In-

Challenge dustries (from the previous problem) are operating at only 75 percent of capacity. What is

Problems required external financing over the next year?

28. Capacity Use and External Financing. If Growth Industries from problem 26 is operating

at only 75 percent of capacity, how much can sales grow before the firm will need to raise

any external funds? Assume that once fixed assets are operating at capacity, they will need

to grow thereafter in direct proportion to sales.

29. Internal Growth. For many firms, cash and inventory needs may grow less than propor-

tionally with sales. When we recognize this fact, will the firm™s internal growth rate be

higher or lower than the level predicted by the formula

retained earnings

Internal growth rate =

assets

30. Spreadsheet Problem. Use a spreadsheet like that in Figure 1.17 to answer the following

questions about Executive Fruit:

a. What would be required external financing if the growth rate is 15 percent and the divi-

dend payout ratio is 60 percent?

b. Given the assumptions in part (a), what would be the amount of debt and equity issued if

the firm wants to maintain its debt-equity ratio at a level of 2/3?

c. What formulas would you put in cells C23 and C24 of the spreadsheet in Figure 1.17 to

maintain the debt-equity ratio at 2/3, while forcing the balance sheet to balance (that is,

forcing debt + equity = total assets)?

1 The firm cannot issue debt, and its dividend payment is effectively fixed, which limits re-

Solutions to tained earnings to $40. Therefore, the balancing item must be new equity issues. The firm

Self-Test must raise $200 “ $40 = $160 through equity sales in order to finance its plans for $200 in

asset acquisitions.

Questions

2 a. The total amount of external financing is unchanged, since the dividend payout is un-

changed. The $100,000 increase in total assets will now be financed by a mixture of debt

and equity. If the debt-equity ratio is to remain at 2„3, the firm will need to increase eq-

uity by $60,000 and debt by $40,000. Since retained earnings already increase share-

holders™ equity by $36,000, the firm needs to issue an additional $24,000 of new equity

and $40,000 of debt.

Financial Planning 107

b. If dividends are frozen at $64,000 instead of increasing to $72,000 as envisioned in Table

1.15, then the required external funds fall by $8,000 to $56,000.

3 a. The company currently runs at 80 percent of capacity given the current level of fixed as-

sets. Sales can increase until the company is at 100 percent of capacity; therefore, sales

can increase to $60 million — (100/80) = $75 million.