Solutions Manual

CHAPTER 15
FINANCIAL FORECASTING
FOR STRATEGIC GROWTH
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. The reason is that, ultimately, sales are the driving force behind a
business. A firms assets, employees, and, in fact, just about every aspect
of its operations and financing exist to directly or indirectly support
sales. Put differently, a firms future need for things like capital assets,
employees, inventory, and financing are determined by its future sales
level.
2. Accounts payable, accrued wages and accrued taxes increase
spontaneously and proportionately with sales. Retained earnings
increase, but not proportionately.
3. False. At low growth rates, internal financing will take care of the firms
needs.
4. The internal growth rate is greater than 15%, because at a 15% growth
rate the negative EFN indicates that there is excess internal financing. If
the internal growth rate is greater than 15%, then the sustainable growth
rate is certainly greater than 15%, because there is additional debt
financing used in that case (assuming the firm is not 100% equityfinanced). As the retention ratio is increased, the firm has more internal
sources of funding, so the EFN will decline. Conversely, as the retention
ratio is decreased, the EFN will rise. If the firm pays out all its earnings
in the form of dividends, then the firm has no internal sources of funding
(ignoring the effects of accounts payable); the internal growth rate is zero
in this case and the EFN will rise to the change in total assets.
II. Problems
Problem 1 (Pro Forma Statements)
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Financial Forecasting for Strategic Growth

It is important to remember that equity will not increase by the same

percentage as the other assets. If every other item on the income statement
and balance sheet increases by 15 percent, the pro forma income statement
and balance sheet will look like this:
Pro forma
Income Statement
Sales
Costs
Net income

Pro forma
Balance Sheet

26,450 Assets
19,205
7,245 Total

18,170 Debt
_______ Equity
18,170 Total

5,980
12,190
18,170

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity Debt
Equity = 18,170 5,980 = 12,190
Equity increased by:
Equity increase = 12,190 10,600 = 1,590
Net income is 7,245 but equity only increased by 1,590; therefore, a
dividend of 5,655 must have been paid. Dividends paid is the additional
financing needed.
Dividend = 7,245 1,590 = 5,655
Problem 2 (Calculating EFN)
An increase of sales to 7,424 is an increase of:
Sales increase = (7,424 6,300) / 6,300 = .18 or 18%
Assuming costs and assets increase proportionally, the pro forma financial
statements will look like this:
Pro forma
Income Statement
Sales
Costs

Pro forma
Balance Sheet

7,434 Assets
4,590
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21,594 Debt
_______ Equity

12,400
8,744

Financial Forecasting for Strategic Growth

Net income

2,844 Total

21,594 Total

Chapter 15

21,144

If no dividends are paid, the equity account will increase by the net income,
so:
Equity = 5,900 + 2,844 = 8,744
So the EFN is:
EFN = Total assets Total liabilities and equity
EFN = 21,594 21,144 = 450
Problem 3 (Calculating EFN)
An increase of sales to 21,840 is an increase of:
Sales increase = (21,840 19,500) / 19,500 = .12 or 12%
Assuming costs and assets increase proportionally, the pro forma financial
statements will look like this:
Pro forma
Income Statement

Pro forma
Balance Sheet

Sales

21,840 Assets

Costs
EBIT

16,800
5,040 Total

Taxes (40%)
Net income

109,76 Debt
0
______ _ Equity
109,76 Total
0

52,500
79,208
99,456

2,016
3,024

The payout ratio is constant, so the dividends paid this year is the payout
ratio from last year times net income, or:
Dividends = (1,400 / 2,700) (3,024) = 1,568
The addition to retained earnings is:
Addition to retained earnings = 3,024 1,568 = 1,456
And the new equity balance is:
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Financial Forecasting for Strategic Growth

Equity = 45,500 + 1,456 = 46,956

So the EFN is:
EFN = Total assets Total liabilities and equity
EFN = 109,760 99,456 = 10,304
Problem 4 (Sales and Growth)
The maximum percentage sales increase is the sustainable growth rate. To
calculate the sustainable growth rate, first we need to calculate the ROE,
which is:
ROE = NI / TE
ROE = 8,910 / 56,000 = .1591 or 15.91%
The plowback ratio, b, is one minus the payout ratio, so:
b = 1 .30 = .70
Now we can use the sustainable growth rate equation to get:
Sustainable growth rate = (ROE b) / [1 (ROE b)]
Sustainable growth rate = [.1591(.70)] / [1 .1591(.70)] = .1253 or 12.53%
So, the maximum peso increase in sales is:
Maximum increase in sales = 42,000 (.1253) = 5,264.03
Problem 5 (Calculating Retained Earnings from Pro Forma Income)
Assuming costs vary with sales and a 20 percent increase in sales, the pro
forma income statement will look like this:
Jordan Corporation
Pro Forma Income Statement
45,600.00
22,080.00

Sales
Costs
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Financial Forecasting for Strategic Growth

Taxable income
Taxes (34%)
Net income

Chapter 15

23,520.00
7,996.80
15,523.20

The payout ratio is constant, so the dividends paid this year is the payout
ratio from last year times net income, or:
Dividends = (5,200/12,936) (15,523.20) = 6,240.00
And the addition to retained earnings will be:
Addition to retained earnings = 15,523.20 6,240 = 9,283.20
Problem 6 (Applying Percentage of Sales)
Below is the balance sheet with the percentage of sales for each account on
the balance sheet. Notes payable, total current liabilities, long-term debt, and
all equity accounts do not vary directly with sales.
Jordan Corporation
Balance Sheet
()

Assets
Current assets
Cash
Accounts receivable
Inventory
Total
Fixed assets
Net plant and equipment
Total assets
Liabilities and Owners equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Owners equity
Common stock and paid-in surplus
Retained earnings
15-5

(%)

3,050
6,900
7,600
17,550

8.03
18.16
20.00
46.18

34,500
52,050

90.79
136.97

1,300
6,800
8,100
25,000

3.42
n/a
n/a
n/a

15,000
3,950

n/a
n/a

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Financial Forecasting for Strategic Growth

18,950
52,050

Total
Total liabilities and Owners equity

n/a
n/a

Problem 7 (External Financing Requirements)

a., b., & c.
Lewis Company
Pro Forma Income Statement
December 31, 2012
(Millions of Pesos)

Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

2011
8,000
7,450
550
150
400
160
240

(1 + g)
(1.2)
(1.2)

Dividends: 1.04 x
150 =
Addition to RE:

1.10
156 x 150
84

1st Pass
2012
9,600
8,940
660
150
510
204
306

AFN
Effects

165
141

+30*

2nd Pass
2012
9,600
8,940
660
180
480
192
288

+24**

189
99

* in interest expense = (51 + 248) x 0.10 = 30.

** in 2012 Dividends = 368/16.96 x 1.10 = 24.
in addition to retained earnings = 99 141 = 42.
Lewis Company
Pro Forma Balance Sheet
December 31, 2012
(Millions of Pesos)

Cash

2011

80

(1 + g)
(1.2)

Additions

Accounts
15-6

1st
Pass
2012

96

AFN
Effects

2nd
Pass
2012
96

Financial Forecasting for Strategic Growth

receivable
Inventory
Total current
assets
Fixed assets
Total assets
Accounts
payable
Accruals
Notes payable
Total current
liabilities
Long-term debt
Total debt
Common stock
Retained
earnings
Total liabilities
and equity

240
720
1,04
0
3,200
4,24
0

160
40
252

Chapter 15

(1.2)
(1.2)

288
864

288
864
1,248

(1.2)

1,24
8
3,840
5,08
8

192
48
252

192

(1.2)
(1.2)

452
1,244
1,69
6
1,605

492
1,244
1,73
6
1,605

939

141*

4,24
0

1,080
4,42
1

667

AFN =

*See Income Statement, 1st pass.

** CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x 5,088 = 2,035.
Maximum increase in debt = 2,035 1,736 = 299.
Maximum current liabilities = 1,248/2.3 = 543.
Increase in notes payable = 543 492 = 51.
Increase in long-term debt = 299 51 = 248.
Increase in common stock = 667 299 = 368.
*** in RE = 99 141 = 42.
Problem 8 (Long-term financing needed)

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3,840
5,088

48
303

+51**

543
+248**

1,492
2,035

+368**

1,973

42***

1,038
5,046

42

Chapter 15

Financial Forecasting for Strategic Growth

a. Total liabilities and equity = Accounts payable + Long-term debt +

Common stock + Retained earnings
1,200,000 = 375,000 + LTD + 425,000 + 295,000
Long-term debt (LTD) = 105,000
Total debt = Accounts payable + Long-term debt
Total debt = 375,000 + 105,000 = 480,000
Alternatively;
Total debt = Total liabilities and equity Common stock Retained earnings
Total debt = 1,200,000 425,000 295,000 = 480,000
b. Assets/Sales (A*/S) = 1,200,000/2,500,000 = 48%
Liabilities/Sales (L*/S) = 375,000/2,500,000 = 15%
2012 Sales = (1.25) (2,500,000) = 3,125,000
AFN = (A*/S) (S) (L*/S) (S) PS2 (1 D)
= (0.48) (625,000) (0.15) (625,000) (0.06) (3,125,000)
(0.6)
75,000
AFN = 300,000 93,750 112,500 75,000 = 18,750
Problem 9 (Additional Funds Needed)
Cash
Accounts receivable
Inventory
Net fixed assets
Total assets

100
200
200
500
1,000

x
x
x
+

2
2
2
0.0

=
=
=
=

200
400
400
500
1,500

Accounts payable
Notes payable
Accruals
Long-term debt
Common stock
Retained earnings

40

100
150*
100
400
100
290

50
150
50
400
100
250

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Financial Forecasting for Strategic Growth

Total liabilities and equity

1,000

Chapter 15

1,140
360

AFN =
*150 + 360 = 510
Capacity sales = Current sales/0.5 = 1,000/0.5 = 2,000
Target FA/S ratio = 500/2,000 = 0.25

Target FA = 0.25 (2,000) = 500 = Required FA. Since the firm currently
has 500 of FA, no new FA will be required.
Addition to RE = P (S2) (1 Payout ratio) = 0.05 (2,000) (0.4) = 40
Problem 10 (Additional Funds Needed)
Percent of Sales Table
Cash
Accounts receivable
Inventory
Current assets
(spontaneous)

5% Accounts payable
30 Accrued expenses
20
55% Current liabilities
(spontaneous)

30.0%
2.5
32.5%

Sales = 20% (3,000,000) = 600,000

New Sales level = 3,000,000 + 600,000 = 3,600,000
New Funds Required (NFR) = A (S) L (S) PS2 (1 D)
NFR = 55% (600,000) 32.5% (600,000) 8% (3,600,000) (1 7)
NFR = 330,000 195,000 86,400 = 48,600
Problem 11 (Percent-of-sales method)
Sales = (10%) (100,000,000) = 10,000,000
New Sales level = 100,000,000 + 10,000,000 = 110,000,000
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Financial Forecasting for Strategic Growth

New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)

= (85,000,000/100) (10,000,000) (25,000,000/100) (10,000,000)
.07 (110,000,000) (.60)
NFR = 8,500,000 2,500,000 4,620,000 = 1,380,000
Problem 12 (Percent-of-sales method)
a. Sales = (15%) (300,000,000) = 45,000,000
New Sales level = 300,000,000 + 45,000,000 = 345,000,000
New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)
= (240,000,000/300,000,000) (45,000,000)
(120,000,000/300,000,000) (45,000,000) .08
(345,000,000) (1 .25)
NFR

= 36,000,000 18,000,000 20,700,000 = (2,700,000)

A negative figure for new funds required indicated that an excess of

funds (2,700,000) is available for new investment. No external funds
are needed.
b. New Funds Required (NFR) = (A/S) (S) (L/S) (S) PS 2 (1 D)
= 36,000,000 18,000,000 .095 (345,000,000) (1 .5)
= 36,000,000 18,000,000 16,387,500
NFR

= 1,612,500 external funds required

The net profit margin increased slightly, from 8% to 9.5%, which

decreases the need for external funding. The dividend payout ratio
increased tremendously, however, from 25% to 50%, necessitating more
external financing. The effect of the dividend policy change overpowered
the effect of the net profit margin change.
Problem 13 (External Funds Requirement)
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Financial Forecasting for Strategic Growth

Chapter 15

a. Sales = (15%) (100,000,000) = 15,000,000

Spontaneous Assets = 5% + 15% + 20% + 40% = 80%
Spontaneous Liabilities = 15% + 10% = 25%
New Sales level = 100,000,000 + 15,000,000 = 115,000,000
New Funds Required (NFR) = A (S) L (S) PS2 (1 D)
NFR = 80% (600,000) 25% (600,000) 10% (115,000,000) (1 .5)
NFR = 12,000,000 3,750,000 5,750,000 = 2,500,000
b. If Mercury 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 forced Mercury to seek more external funds.

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