Chapter 4, Problem 4QP

Summary Introduction

To determine: The external financing needed.

Introduction:

The costs and assets are proportionate to sales, whereas equity and debt are not. The dividend paid during the year is $2,300. 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 $6,116.

Explanation of Solution

Given information:

The dividend paid during the year is $2,300 and the company wants to sustain a constant payout ratio. The estimated sales during the next year are $30,360.

Formulae:

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

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

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

Compute increase in percentage of sales:

$\begin{array}{c}\text{Increase in percentage of sales}=\frac{\text{Projected sales}-\text{Current sales}}{\text{Current sales}}\\ =\frac{\$30,360-\$26,400}{\begin{array}{l}\$26,400\end{array}}\times 100\\ =\frac{\$3,960}{\$26,400}\\ =15\%\end{array}$

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

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

$\begin{array}{c}\text{Increase in sales}=\left(\text{Current sales}\times \text{Percentage of increase in sales}\right)+\text{Current sales}\\ =\left(\text{\$26,400}\times \frac{15}{100}\right)+\text{\$26,400}\\ =\$3,960+\$26,400\\ =\$30,360\end{array}$

Hence, the increase in sales is $30,360.

$\begin{array}{c}\text{Increase in cost}=\left(\text{Current cost}\times \text{Percentage of increase in sales}\right)+\text{Current cost}\\ =\left(\text{\$17,300}\times \frac{15}{100}\right)+\$17,300\\ =\$2,595+\$17,300\\ =\$19,895\end{array}$

Hence, the increase in cost is $19,895.

$\begin{array}{c}\text{Increase in value of tax}=\left(\$3,640\times \frac{15}{100}\right)+\$3,640\\ =\$546+\$3,640\\ =\$4,186\end{array}$

Hence, the increase in value of tax is $4,186.

Pro forma income statement

R incorporation Pro forma income statement
Particulars	Amount ($)
Sales	$30,360
Costs	$19,895
Taxable income	$10,465
Taxes (40%)	$4,186
Net income	$6,279

Hence, the net income is $6,279.

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

$\begin{array}{c}\text{Increase in assets}=\left(\text{Existing assets}\times \text{Percentage of increase in sales}\right)+\text{Existing}\text{assets}\\ =\left(\text{\$65,000}\times \frac{15}{100}\right)+\$65,000\\ =\$9,750+\$65,000\\ =\$74,750\end{array}$

Hence, the increase in assets is $74,750.

Compute dividend and additional retained earnings:

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

$\begin{array}{c}\text{Dividend}=\frac{\text{Current year's dividend}}{\text{Net Income}}\times \text{Projected Net Income}\\ =\left(\frac{\text{\$2,300}}{\$5,460}\right)\times \$6,279\\ =0.4212\times \$6,279\\ =\$2,644.71\end{array}$

Hence, the dividend is $2,644.71.

$\begin{array}{c}\text{Additional retained earnings}=\text{Net income}-\text{Dividend}\\ =\text{\$6,279}-\text{\$2,644}\text{.71}\\ =\$3,634\end{array}$

Hence, the additional earnings are $3,634.

Compute total equity:

$\begin{array}{c}\text{Total equity balance}=\text{Current equity}+\text{Additional equity}\\ =\text{\$37,600}+\text{\$3,634}\\ =\text{\$41,234}\end{array}$

Hence, the total equity is $41,234.

Pro forma balance sheet

R incorporation Pro forma Balance Sheet
Particulars	Amount ($)	Particulars	Amount ($)
Assets	$74,750	Debt	$27,400
		Equity	$41,234
Total	$74,750	Total	$68,634

Compute external financing needed:

$\begin{array}{c}\text{External financing needed}=\text{Total assets}-\text{Total liabilities and Owner's equity}\\ =\text{\$74,750}-\text{\$68,634}\\ =\$6,116\end{array}$

Hence, the external financing needed is $6,116.