Chapter 14 Problems

1. Baxter Video Products’ sales are expected to increase from $5 million in 2007 to $6
million in 2008 or by 20%. Its assets totaled $3 million at the end of 2007. Baxter is at
full capacity, so its assets must grow at the same rate as projected sales. At the end of
2007, current liabilities were $1 million, consisting of $250,000 of accounts payable,
$500,000 of notes payable, and $250,000 of accruals. The after-tax profit margin is
forecasted to be 5%, and the forecasted payout ratio is 70%. Use the AFN formula to
forecast Baxter’s additional funds needed for the coming year.

AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(1 - d)

 $3,000,000   $500,000 
=  $1,000,000 -   $1,000,000 - 0.05($6,000,000)(1 - 0.7)
 $5,000,000   $5,000,000 
= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)
= $600,000 - $100,000 - $90,000
= $410,000.

4. Bannister Legal Services generated $2.0 million in sales during 2007, and its yearend
total assets were $1.5 million. Also, at year-end 2007, current liabilities were $500,000,
consisting of $200,000 of notes payable, $200,000 of accounts payable, and $100,000 of
accruals. Looking ahead to 2008, the company estimates that its assets must increase by
75 cents for every $1 increase in sales. Bannister’s profit margin is 5%, and its payout
ratio is 60%. How large a sales increase can the company achieve without having to raise
funds externally?

S2007 = $2,000,000; A2007 = $1,500,000; CL2007 = $500,000;

NP2007 = $200,000; A/P2007 = $200,000; Accruals2007 = $100,000;
PM = 5%; d = 60%; A*/S0 = 0.75.

AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(1 - d)

 $300,000 
= (0.75)∆S -   ∆S -(0.05)(S1)(1 - 0.6)
 $2,000,000 
= (0.75)∆S - (0.15)∆S - (0.02)S1
= (0.6)∆S - (0.02)S1
= 0.6(S1 - S0) - (0.02)S1
= 0.6(S1 - $2,000,000) - (0.02)S1
= 0.6S1 - $1,200,000 - 0.02S1
$1,200,000 = 0.58S1
 $2,068,965.52 = S1.

Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional

funds being needed.

5. At year-end 2007, total assets for Bertin Inc. were $1.2 million and accounts payable
were $375,000. Sales, which in 2007 were $2.5 million, are expected to increase by 25%
in 2008. Total assets and accounts payable are proportional to sales, and that relationship
will be maintained. Bertin typically uses no current liabilities other than accounts
payable. Common stock amounted to $425,000 in 2007, and retained earnings were
$295,000. Bertin plans to sell new common stock in the amount of $75,000. The firm’s
profit margin on sales is 6%; 40% of earnings will be paid out as dividends.

a. What was Bertin’s total debt in 2007?

b. How much new, long-term debt financing will be needed in 2008? (Hint:
AFN _ New stock _ New long-term debt.) Do not consider any financing feedback
effects

Total liabilities Accounts Long - term Common Retained

a.     .
and equity Payable debt stock earnings

$1,200,000 = $375,000 + Long-term debt + $425,000 + $295,000

Long-term debt = $105,000.

Total debt = Accounts payable + Long-term debt

= $375,000 + $105,000 = $480,000.

Alternatively,

Total
Total debt = liabilities - Common stock - Retained earnings
and equity
= $1,200,000 - $425,000 - $295,000 = $480,000.
b. Assets/Sales (A*/S) = $1,200,000/$2,500,000 = 48%.
L*/Sales = $375,000/$2,500,000 = 15%.
2006 Sales = (1.25)($2,500,000) = $3,125,000.

AFN = (A*/S)(∆S) - (L*/S)(∆S) - MS1(1 - d) - New common stock

= (0.48)($625,000) - (0.15)($625,000) - (0.06)($3,125,000)(0.6) - $75,000
= $300,000 - $93,750 - $112,500 - $75,000 = $18,750.
 Alternatively, using the percentage of sales method:
Forecast
Basis % Additions (New
2007 2008 Sales Financing, R/E) Pro
Forma
Total assets $1,200,000 0.48
$1,500,000
Current liabilities $ 375,000 0.15 $ 468,750
Long-term debt 105,000 105,000
Total debt $ 480,000 $ 573,750
Common stock 425,000 75,000* 500,000
Retained earnings 295,000 112,500** 407,500
Total common equity $ 720,000 $ 907,500
Total liabilities
and equity $1,200,000
$1,481,250

AFN = Long-term debt = $ 18,750

*Given in problem that firm will sell new common stock = $75,000.
**PM = 6%; Payout = 40%; NI2008 = $2,500,000 x 1.25 x 0.06 = $187,500.
Addition to RE = NI x (1 - Payout) = $187,500 x 0.6 = $112,500

6. The Booth Company’s sales are forecasted to increase from $1,000 in 2007 to $2,000
in 2008. Here is the December 31, 2007, balance sheet:

Cash $100 Accounts payable $50

Accounts receivable $200 Notes payable $150
Inventories $200 Accruals $50
Net fixed assets $500 Long-term debt $400
Common stock $100
Retained earnings $250
Total assets $1,000 Total liabilities and equity $1,000

Booth’s fixed assets were used to only 50% of capacity during 2007, but its current assets
were at their proper levels. All assets except fixed assets increase at the same rate as
sales, and fixed assets would also increase at the same rate if the current excess capacity
did not exist. Booth’s after-tax profit margin is forecasted to be 5%, and its payout ratio
will be 60%. What is Booth’s additional funds needed (AFN) for the coming year?

Cash $ 100.00  2 = $ 200.00

Accounts receivable 200.00  2 = 400.00
Inventories 200.00  2 = 400.00
Net fixed assets 500.00 + 0.0 = 500.00
Total assets $1,000.00 $1,500.00

Accounts payable $ 50.00  2 = $ 100.00

Notes payable 150.00 150.00 + 360.00 = 510.00
Accruals 50.00  2 = 1 00.00
Long-term debt 400.00 400.00
Common stock 100.00 100.00
Retained earnings 250.00 + 40 = 290.00
Total liabilities
and equity $1,000.00 $1,140.00
AFN $ 360.00

Capacity sales = 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 fixed assets, no new fixed assets will be required.

Addition to RE = M(S1)(1 - Payout ratio) = 0.05($2,000)(0.4) = $40.