Chapter 3 Tutorial Solutions Corporate Finance Free Essay Example

CHAPTER 3 TUTORIAL SOLUTIONS 21. Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look like this: MOOSE TOURS INC.

Pro Forma Income Statement Sales$1,114,800 Costs867,600 Other expenses22,800 EBIT$224,400 Interest14,000 Taxable income$210,400 Taxes(35%)73,640 Net income$136,760 The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = ($33,735/$112,450)($136,760) Dividends = $41,028 And the addition to retained earnings will be: Addition to retained earnings = $136,760 – 41,028

Addition to retained earnings = $95,732 The new retained earnings on the pro forma balance sheet will be: New retained earnings = $182,900 + 95,732 New retained earnings = $278,632 The pro forma balance sheet will look like this: MOOSE TOURS INC. Pro Forma Balance Sheet AssetsLiabilities and Owners’ Equity ————————————————- Current assets Current liabilities Cash$30,360Accounts payable$81,600 Accounts receivable48,840Notes payable17,000 Inventory104,280Total$98,600 Total$183,480Long-term debt158,000 Fixed assets Net plant andOwners’ equity quipment495,600Common stock and paid-in surplus$140,000 Retained earnings278,632 Total$418,632 Total liabilities and owners’ Total assets$679,080equity$675,232 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = $679,080 – 675,232 EFN = ,848 22.

First, we need to calculate full capacity sales, which is: Full capacity sales = $929,000 / . 75 Full capacity sales = $1,238,667 The full capacity ratio at full capacity sales is: Full capacity ratio = Fixed assets / Full capacity sales Full capacity ratio = $413,000 / $1,238,667 Full capacity ratio = . 33342

The fixed assets required at full capacity sales is the full capacity ratio times the projected sales level: Total fixed assets = . 33342($1,114,800) = $371,700 So, EFN is: EFN = ($183,480 + 371,700) – $675,232 = –$120,052 Note that this solution assumes that fixed assets are decreased (sold) so the company has a 100 percent fixed asset utilization.

If we assume fixed assets are not sold, the answer becomes: EFN = ($183,480 + 413,000) – $675,232 = –$78,752 23. The D/E ratio of the company is: D/E = ($85,000 + 158,000) / $322,900 D/E = . 7526 So the new total debt amount will be: New total debt = . 7526($418,632)

New total debt = $315,044 This is the new total debt for the company. Given that our calculation for EFN is the amount that must be raised externally and does not increase spontaneously with sales, we need to subtract the spontaneous increase in accounts payable. The new level of accounts payable will be, which is the current accounts payable times the sales growth, or: Spontaneous increase in accounts payable = $68,000(. 20) Spontaneous increase in accounts payable = $13,600 This means that $13,600 of the new total debt is not raised externally. So, the debt raised externally, which will be the EFN is:

EFN = New total debt – (Beginning LTD + Beginning notes payable + Spontaneous increase in AP) EFN = $315,044 – ($158,000 + 68,000 + 17,000 + 13,600) = $58,444 The pro forma balance sheet with the new long-term debt will be: MOOSE TOURS INC. Pro Forma Balance Sheet AssetsLiabilities and Owners’ Equity ————————————————- Current assets Current liabilities Cash$30,360Accounts payable$81,600 Accounts receivable48,840Notes payable17,000 Inventory104,280Total$98,600 Total$183,480Long-term debt216,444 Fixed assets Net plant andOwners’ equity equipment495,600Common stock and paid-in surplus$140,000

Retained earnings278,632 Total$418,632 Total liabilities and owners’ Total assets$679,080equity$733,676 The funds raised by the debt issue can be put into an excess cash account to make the balance sheet balance. The excess debt will be: Excess debt = $733,676 – 679,080 = $54,596 To make the balance sheet balance, the company will have to increase its assets. We will put this amount in an account called excess cash, which will give us the following balance sheet: MOOSE TOURS INC. Pro Forma Balance Sheet AssetsLiabilities and Owners’ Equity Current assets Current liabilities Cash$30,360Accounts payable$81,600

Excess cash54,596 Accounts receivable48,840Notes payable17,000 Inventory104,280Total$98,600 Total$238,076Long-term debt216,444 Fixed assets Net plant andOwners’ equity equipment495,600Common stock and paid-in surplus$140,000 Retained earnings278,632 Total$418,632 Total liabilities and owners’ Total assets$733,676equity$733,676 The excess cash has an opportunity cost that we discussed earlier. Increasing fixed assets would also not be a good idea since the company already has enough fixed assets. A likely scenario would be the repurchase of debt and equity in its current capital structure weights.

The company’s debt/assets and equity/assets are: Debt/assets = . 7526 / (1 + . 7526) = . 43 Equity/assets = 1 / (1 + . 7526) = . 57 So, the amount of debt and equity needed will be: Total debt needed = . 43($679,080) = $291,600 Equity needed = . 57($679,080) = $387,480 So, the repurchases of debt and equity will be: Debt repurchase = ($98,600 + 216,444) – 291,600 = $23,444 Equity repurchase = $418,632 – 387,480 = $31,152 Assuming all of the debt repurchase is from long-term debt, and the equity repurchase is entirely from the retained earnings, the final pro forma balance sheet will be:

MOOSE TOURS INC. Pro Forma Balance Sheet AssetsLiabilities and Owners’ Equity ————————————————- Current assets Current liabilities Cash$30,360Accounts payable$81,600 Accounts receivable48,840Notes payable17,000 Inventory104,280Total$98,600 Total$183,480Long-term debt193,000 Fixed assets Net plant andOwners’ equity equipment495,600Common stock and paid-in surplus$140,000 Retained earnings247,480 Total$387,480 Total liabilities and owners’ Total assets$679,080equity$679,080 30. Since the company issued no new equity, shareholders’ equity increased by retained earnings.

Retained earnings for the year were: Retained earnings = NI – Dividends Retained earnings = $95,000 – 42,000 Retained earnings = $53,000 So, the equity at the end of the year was: Ending equity = $230,000 + 53,000 Ending equity = $283,000 The ROE based on the end of period equity is: ROE = $95,000 / $283,000 ROE = . 3357 or 33. 57% The plowback ratio is: Plowback ratio = Addition to retained earnings/NI Plowback ratio = $53,000 / $95,000 Plowback ratio = . 5579 or 55. 79% Using the equation presented in the text for the sustainable growth rate, we get:

Sustainable growth rate = (ROE ? b) / [1 – (ROE ? b)] Sustainable growth rate = [. 3357(. 5579)] / [1 – . 3357(. 5579)] Sustainable growth rate = . 2304 or 23. 04% The ROE based on the beginning of period equity is ROE = $95,000 / $230,000 ROE = . 4130 or 41. 30% Using the shortened equation for the sustainable growth rate and the beginning of period ROE, we get: Sustainable growth rate = ROE ? b Sustainable growth rate = . 4130 ? .5579 Sustainable growth rate = . 2304 or 23. 04% Using the shortened equation for the sustainable growth rate and the end of period ROE, we get:

Sustainable growth rate = ROE ? b Sustainable growth rate = . 3357 ? .5579 Sustainable growth rate = . 1873 or 18. 73% Using the end of period ROE in the shortened sustainable growth rate results in a growth rate that is too low. This will always occur whenever the equity increases. If equity increases, the ROE based on end of period equity is lower than the ROE based on the beginning of period equity. The ROE (and sustainable growth rate) in the abbreviated equation is based on equity that did not exist when the net income was earned.