Concept explainers
EFN and Sustainable Growth [LO2, 3] Redo Problem 26 using sales growth rates of 30 and 35 percent in addition to 20 percent. Illustrate graphically the relationship between EFN and the growth rate, and use this graph to determine the relationship between them. At what growth rate is the EFN equal to zero? Why is this sustainable growth rate different from that found by using the equation in the text?
To determine:
- The relationship between external financing needed and growth rate
- The growth rate at which EFN is zero
- Reason for the difference between internal growth rates using graphical method and equation method
Introduction:
By using the graphical representation, the relationship between external financing needed and growth rate can be determined.
Answer to Problem 28QP
The growth rate at which the external financing is zero
Explanation of Solution
Given information:
The various growth rates in addition to 20% are 30% and 35%
Formulae:
Compute pro forma income statement at the rates of 20%, 30%, 35%:
Pro forma statement at 30% growth rate
Pro forma income statement | ||
Particulars | CurrentyearAmount($) | Amount($)(30%) |
Sales | $891,600 | $1,159,080 |
Costs | $693,600 | $901,680 |
Other expenses | $18,240 | $23,712 |
EBIT | $179,760 | $233,688 |
Interest paid | $13,400 | $13,400 |
Taxable income | $166,360 | $220,288 |
Taxes (35%) | $58226 | $77,101 |
Net income | $108,134 | $143,187 |
Hence, the current year’s net income increases at 30% growth rate.
Compute dividend and addition to retained earnings:
Dividend and addition to retained earnings for the rate of 15%growth:
Hence, dividend and addition to retained earnings are $47,251 and $95,936.
Compute new long-term debt, keeping debt equity constant:
Hence, debt equity ratio is 0.77616.
New long-term debt
Hence, new long-term debt is $209,902.
Pro forma balance for the growth rate of 30%
Pro forma balance sheet | |||
Assets | Amount($) | Liabilities | Amount($) |
Current assets: | Current liabilities: | ||
Cash | $31,564 | Accounts payable | $84,760 |
Accounts receivable | $48,191 | Notes payable | $16,320 |
Inventory | $108,420 | ||
Total | $188,175 | Total | $101,080 |
Fixed assets: | Long-term debt | $209,902 | |
Net plant and equipment | $4515,450 | Owner's equity: | |
Common stock and paid in surplus | $130,000 | ||
Retained earnings | $270,666 | ||
Total Owner's equity | $400,666 | ||
Total | $703,625 | Total | $711,648 |
Therefore, the excess debt raised is $8022($711648-$703,625)
Compute external financing needed:
Hence, external financing needed at the grow rate of 30% is $54,902.
Pro forma income statement at the rate of 35% growth rate
Pro forma income statement | ||
Particulars | CurrentyearAmount($) | Amount($)(35%) |
Sales | $891,600 | $1,203,660 |
Costs | $693,600 | $ 936,360 |
Other expenses | $18,240 | $24,624 |
EBIT | $179,760 | $242,676 |
Interest paid | $13,400 | $13,400 |
Taxable income | $166,360 | $229,276 |
Taxes (35%) | $58226 | $80,247 |
Net income | $108,134 | $149,029 |
Hence, net income increased at the rate of 35%
Compute external financing needed at the growth rate of 35%
Compute dividend and addition to retained earnings for the rate of 35%
Hence, dividend and addition to retained earnings is $49,179 and $99,850.
Hence, total retained earnings are $274,580.
Compute new long-term debt:
The new long term debt can be determined by using the below formula
Hence, new long-term debt is $209,680
Pro forma balance for the growth rate of 35%
Pro forma balance sheet | |||
Assets | Amount($) | Liabilities | Amount($) |
Current assets: | Current liabilities: | ||
Cash | $32,778 | Accounts payable | $88,020 |
Accounts receivable | $50,045 | Notes payable | $16,320 |
Inventory | $112,590 | ||
Total | $195,413 | Total | $104,340 |
Fixed assets: | Long-term debt | $209,680 | |
Net plant and equipment | $535,275 | Owner's equity: | |
Common stock and paid in surplus | $130,000 | ||
retained earnings | $274,580 | ||
Total Owner's equity | $404,580 | ||
Total | $730,688 | Total | $718,600 |
Therefore, the excess debt raised is ($718,600-$730,688) is $-12088
Note: At 35% growth rate, the firm needs $12088 addition to external debt. Thus, existing financial need of $54,680 is added to $12,088.
Compute external financing needed:
Hence, external financing needed at the growth rate of 30% is $66,767.
The rate at which EFN is zero:
The rate at which external financing needed is zero at 30% growth rate
The internal growth rate differs from the calculated by using equation in the text:
The (ROE x b) is the element which is used throughout the text. This is based on the ROE using ending balance sheet of equity and beginning balance sheet equity whereas the sustainable growth rate and ROE calculated by using abbreviated equation is based on the equity that do not exist when the net income is earned.
Thus, negative external financing needed indicates that the company has more funds which can be used to reduce current liabilities, debts etc. Thus, these represents the relationship between external financing needed and growth rates.
Want to see more full solutions like this?
Chapter 4 Solutions
Fundamentals of Corporate Finance
- What is meant by the term “self-supporting growth rate”? How is this raterelated to the AFN equation, and how can that equation be used to calculatethe self-supporting growth rate?arrow_forwardAssuming the following ratios are constant, what is the sustainable growth rate? PLEASE INCLUDE EXCEL FUNCTIONS. Thank you! Assuming the following ratios are constant, what is the sustainable growth rate? Total asset turnover Profit margin Equity multiplier Payout ratio Plowback ratio 3.40 5.2% Complete the following analysis. Do not hard code values in your calculations. Return on equity 22.98% Sustainable growth rate 1.30 35%arrow_forward10. In the endogenous growth model, suppose that there are three possible uses of time. Let u denote the fraction of time spent working, s the fraction of time spent neither working nor accumulating human capital (call this unem- ployment), and 1 – u – s the fraction of time spent accumulating human capital. Assume that z = 1 and b = 4.2. Also assume that the econ- omy begins period 1 with 100 units of human capital. (a) Suppose that for periods 1, 2, 3, ..., 10, - .7 and s 0.05. Calculate aggregate U = S = consumption, output, and the quantity of human capital in each of these periods.arrow_forward
- The payoffs of an investment are dependent on the state of the economy. The economy can have two states, recession or growth, with equal probability. If the payoff in the event of growth is $140 and in the event of recession is $80, what is the expected payoff for the investment? a.$100 b.$130 c.$120 d.$110arrow_forward16. [EXCEL] Sustainable growth rate: If Newell Corp. has a ROE of 13.7 percent and a dividend payout ratio of 32 percent, what is its sustainable growth rate? please use excel.arrow_forward6. Is it possible to value the company below using the constant growth model? Why or why not? Explain. rf=5% rm 17% beta=0.8 DO = $1 g=50%arrow_forward
- Assume potential GDP is 4,000 and actual GDP is 3,000. If the consumption function is C=300+0.8Yd, how much does government expenditure need to rise by to close the output gap? (Please input the round number without any Euro symbol)arrow_forward[EXCEL] Payback: Refer to Problem 5. What are the payback periods for production systems 1 and 2? If the systems are mutually exclusive and the firm always chooses projects with the lowest payback period, in which system should the firm invest? please use excel. Problem 5 info: 5. [EXCEL] Net present value: Blanda Incorporated management is considering investing in two alternative production systems. The systems are mutually exclusive, and the cost of the new equipment and the resulting cash flows are shown in the accompanying table. If the firm uses a 9 percent discount rate for production system projects, in which system should the firm invest? Year System 1 System 2 0 −$15,000 −$45,000 1 15,000 32,000 2 15,000 32,000 3 15,000 32,000arrow_forwardWill improvements in the long-term growth rate of sales alwaysadd value? Explain your answer.arrow_forward
- Assuming costs vary with sales and a 20 percent increase in sales is projected, create the pro forma income statement. Create a pro forma Balance Sheet. All items will vary with sales. What is the plug variable in order for this to balance? Suppose no dividend is planned to be issued next year. What is the plug variable?arrow_forwardAssume the following ratios are constant. Total asset turnover Profit margin Equity multiplier Payout ratio = || || || || Sustainable growth rate = = 2.27 5.5% 1.74 What is the sustainable growth rate? Note: Do not round intermediate calculations and enter your answer as a percent 38% %arrow_forward5) Which of the following will cause a movement from one point on an AD curve to another point on the same AD curve? a) a change in government expenditures b) a change in the price level c) a change in net exports d) all of the options provided 6) Here is a consumption function: C = CO + MPC(Yd). If MPC is 0.80, then we know that a) as Co rises by $0.80, Yd rises by $1. b) Yd rises by $0.80. c) as Yd rises by $1. Co rises by $0.80. d) as Yd rises by $1, C rises by $0.80. 7) An aggregate demand (AD) curve shows the a) none of the options provided is correct b) quantity of output that people are willing and can afford to buy at different price levels, ceteris paribus c) quantity of output that people are willing as well as able to produce and sell at different price levels, ceteris paribus. d) value of a particular good that people are willing and able to buy at a particular price, ceteris paribus. d) value of a particular good that people are willing and able to buy at a particular…arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning