Chapter 4, Problem 4QP

EFN [LO2] The most recent financial statements for Reply, Inc., are shown here:

Assets and costs are proportional to sales. Debt and equity are not. A dividend of $2,400 was paid, and the company wishes to maintain a constant payout ratio. Next year’s sales are projected to be $32,085. What is the external financing needed?

Summary Introduction

To determine: The external financing needed.

Introduction:

The costs and assets are proportionate to sales whereas equity and debt are not proportionate to sales. The dividend paid during the year is $2,400. The company wants to maintain a constant payout ratio. The difference between the total assets and the total liabilities is known as External financing needed.

Answer to Problem 4QP

The external financing needed is $6,048.

Explanation of Solution

Given Information:

The dividend paid during the year is $2,400 and the company wants to sustain a constant payout ratio. The estimated sales during the next year are $32,085.

Formulae:

The formula to calculate the increase in percentage of sales:

$\text{Increase in percentage of sales}=\frac{\text{Projected sales}-\text{Current sales}}{\text{Current sales}}$

The formula to calculate the dividend:

$\text{Dividend}=\frac{\text{Current year's dividend}}{\text{Net income}}\times \text{Projected net income}$

The formula to calculate the additional retained earnings:

$\text{Additional retained earnings}=\text{Net income}-\text{Dividend}$

Compute the increase in percentage of sales:

$\begin{array}{c}\text{Increase in percentage of sales}=\frac{\text{Projected sales}-\text{Current sales}}{\text{Current sales}}\\ =\frac{\$32,085-\$27,900}{\begin{array}{l}\$27,900\end{array}}\times 100\\ =\frac{\$4,185}{\$27,900}\\ =15\%\end{array}$

Hence, the increase in percentage of sales is 15%.

Compute the changes in the values of income statement by 15%:

$\begin{array}{c}\text{Increase in sales}=\left(\text{Current sales}\times \text{Percentage of increase in sales}\right)+\text{Current sales}\\ =\left(\$27,900\times \frac{15}{100}\right)+\$27,900\\ =\$4,185+\$27,900\\ =\$32,085\end{array}$

Hence, the increase in sales is $32,085.

Compute the increase in cost:

$\begin{array}{c}\text{Increase in cost}=\left(\text{Current cost}\times \text{Percentage of increase in sales}\right)+\text{Current cost}\\ =\left(\text{\$18,100}\times \frac{15}{100}\right)+\$18,100\\ =\$2,715+\$18,100\\ =\$20,815\end{array}$

Hence, the increase in cost is $20,815.

Calculate the increase in the value of taxes:

$\begin{array}{c}\text{Increase in value of taxes}=\left(\text{Current taxes}\times \text{Percentage of increase in sales}\right)+\text{Current taxes}\\ =\left(\$3,920\times \frac{15}{100}\right)+\$3,920\\ =\$588+\$3,920\\ =\$4,508\end{array}$

Hence, the increase in value of taxes is $4,508.

Pro forma income statement

R incorporationPro forma income statement
Particulars	Amount($)
Sales	$32,085
Costs	$20,815
Taxable income	$11,270
Less: Taxes (40%)	$4,508
Net income	$6,762

Hence, the net income is $6,762.

Compute the changes in the values of balance sheet by 15%:

$\begin{array}{c}\text{Increase in assets}=\left(\text{Existing assets}\times \text{Percentage of increase in sales}\right)+\text{Existing}\text{assets}\\ =\left(\text{\$67,000}\times \frac{15}{100}\right)+\$67,000\\ =\$10,050+\$67,000\\ =\$77,050\end{array}$

Hence, the increase in assets is $77,050.

Compute the dividend and additional retained earnings:

Since the company wish to maintain a constant payout ratio, the dividend can be determined as follows:

$\begin{array}{c}\text{Dividend}=\frac{\text{Current year's dividend}}{\text{Net income}}\times \text{Projected net income}\\ =\left(\frac{\text{\$2,400}}{\$5,880}\right)\times \$6,762\\ =0.40816\times \$6,762\\ =\$2,760\end{array}$

Hence, the dividend is $2,760.

$\begin{array}{c}\text{Additional retained earnings}=\text{Net income}-\text{Dividend}\\ =\text{\$6,762}-\text{\$2,760}\\ =\$4,002\end{array}$

Hence, the additional earnings are $4,002.

Compute the total equity:

$\begin{array}{c}\text{Total equity}=\text{Current equity}+\text{Additional equity}\\ =\$39,600+\$4,002\\ =\$43,602\end{array}$

Hence, the total equity is $43,602.

Prepare the Pro forma balance sheet:

R incorporationPro forma Balance Sheet
Particulars	Amount($)	Particulars	Amount($)
Assets	$77,050	Debt	$27,400
		Equity	$43,602
Total	$77,050	Total	$71,002

Compute the external financing needed:

$\begin{array}{c}\text{External financing needed}=\text{Total assets}-\text{Total liabilities and Owner's equity}\\ =\$77,050-\$71,002\\ =\$6,048\end{array}$

Hence, the external financing needed is $6,048.