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A company is forecasting an increase in sales and is using the AFN model to forecast the additional capital that they need to raise. Which of the following factors are likely to
increase the additional funds needed (AFN)?
Question 4-2:
Jill's Wigs Inc. had the following balance sheet last year:
Jill has just invented a non-slip wig for men which she expects will cause sales to double, increasing net income to $1,000. She feels that she can handle the increase without
adding any fixed assets. (1) Will Jill need any outside capital if she pays no dividends? (2) If so, how much?
a. No; zero
b. Yes; $7,700
c. Yes; $1,700
d. Yes; $700
e. No; there will be a $700 surplus.
Question 4-3:
The constant ratio method produces accurate results unless which of the following conditions is (are) present?
Answer 4-1:
b. The company has a high dividend payout ratio.
Additional funds needed
Only answer b will increase AFN; the other statements will decrease
AFN.
Answer 4-2:
d. Yes; $700
Additional funds needed
Formula solution:
S = S; MS = $1,000.
. A* L*
.AFN = (S) - (S) - MS(1 - d) = $2,200 - $500 - $1,000(1) =
S S
$700.
Answer 4-3:
d. Answers a, b, and c all make the constant ratio method inaccurate.
Constant ratio method
Additional Funds Needed
Additional funds needed (AFN) is the amount of money a company must raise from external sources to finance the increase in assets required to support
increased level of sales. Additional funds needed (AFN) is also called external financing needed.
Additional funds needed method of financial planning assumes that the company's financial ratios do not change. In response to an increase in sales, a company
must increase its assets, such as property, plant and equipment, inventories, accounts receivable, etc. Part of this increase in offset by spontaneous increase in
liabilities such as accounts payable, taxes, etc., and part is offset by increase in retained earnings.
Additional funds needed (AFN) is calculated as the excess of required increase in assets over the increase in liabilities and increase in retained earnings.
S S
Additional Funds Needed = Ao Lo S1 PM b
So So
Where,
S/So = percentage increase in sales i.e. change in sales divided by current sales
Lo = current level of liabilities
PM = profit margin
b = retention rate = 1 payout rate
A negative figure for additional funds needed means that there is a surplus of capital.
Example
TransWorld Inc. runs a shipping business and has forecasted a 10% increase in sales over 20Y3. Its assets and liabilities at the end of 20Y2 amounted to $25
billion and $17 billion respectively. Sales for the period were $30 billion and it earned a 4% profit margin. It reinvests 40% of its net income and pays out the rest
to its shareholders. Calculate additional funds needed.
Solution
Additional funds needed = increase in assets increase in liabilities increase in retained earnings
Increase in assets = 20Y2 assets sales growth rate = $25 billion 10% = $2.5 billion
Spontaneous increase in liabilities = 20Y2 liabilities sales growth rate = $17 billion 10% = $1.7 billion
Increase in retained earnings = 20Y3 sales profit margin retention rate = 20Y2 sales (1 + sales growth rate) profit margin retention rate = $30 billion (1
+ 10%)4%40% = $0.528 billion
Additional funds needed = $2.5 billion $1.7 billion $0.528 billion = $0.272 billion
TransWorld must raise $272 million to finance the increased level of sales.