CHAPTER 4

LONG-TERM FINANCIAL PLANNING

AND GROWTH
Answers to Concepts Review and Critical Thinking Questions

1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets,
employees, and, in fact, just about every aspect of its operations and financing exist to directly or
indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees,
inventory, and financing are determined by its future sales level.

2. Two assumptions of the sustainable growth formula are that the company does not want to sell new
equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt-
equity ratio it can grow at a higher rate than the sustainable growth rate. Of course the company could
also grow faster than its profit margin increases, if it changes its dividend policy by increasing the
retention ratio, or its total asset turnover increases.

3. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN
indicates that there is excess internal financing. If the internal growth rate is greater than 15%, then
the sustainable growth rate is certainly greater than 15%, because there is additional debt financing
used in that case (assuming the firm is not 100% equity-financed). As the retention ratio is increased,
the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention
ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then
the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal
growth rate is zero in this case and the EFN will rise to the change in total assets.

4. The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN
indicates that there is excess financing still available. If the firm is 100% equity financed, then the
sustainable and internal growth rates are equal and the internal growth rate would be greater than
20%. However, when the firm has some debt, the internal growth rate is always less than the
sustainable growth rate, so it is ambiguous whether the internal growth rate would be greater than or
less than 20%. If the retention ratio is increased, the firm will have more internal funding sources
available, and it will have to take on more debt to keep the debt/equity ratio constant, so the EFN will
decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero,
both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total
assets.

5. Presumably not, but, of course, if the product had been much less popular, then a similar fate would
have awaited due to lack of sales.

6. Since customers did not pay until shipment, receivables rose. The firm’s NWC, but not its cash,
increased. At the same time, costs were rising faster than cash revenues, so operating cash flow
declined. The firm’s capital spending was also rising. Thus, all three components of cash flow from
assets were negatively impacted.

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7. Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the
extra demand from the lower price.

8. Financing possibly could have been arranged if the company had taken quick enough action.
Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the
need for planning.

9. All three were important, but the lack of cash or, more generally, financial resources ultimately
spelled doom. An inadequate cash resource is usually cited as the most common cause of small
business failure.

10. Demanding cash up front, increasing prices, subcontracting production, and improving financial
resources via new owners or new sources of credit are some of the options. When orders exceed
capacity, price increases may be especially beneficial.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. It is important to remember that equity will not increase by the same percentage as the other assets.
If every other item on the income statement and balance sheet increases by 15 percent, the pro forma
income statement and balance sheet will look like this:

Pro forma income statement Pro forma balance sheet

Sales $ 26,450 Assets $18,170 Debt $ 5,980
Costs 19,205 Equity 12,190
Net income $ 7,245 Total $18,170 Total $ 18,170

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity – Debt

Equity = $18,170 – 5,980
Equity = $12,190

Equity increased by:

Equity increase = $12,190 – 10,600

Equity increase = $1,590

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 Net income is $7,245 but equity only increased by $1,590; therefore, a dividend of:

Dividend = $7,245 – 1,590

Dividend = $5,655

must have been paid. Dividends paid is the plug variable.

2. Here we are given the dividend amount, so dividends paid is not a plug variable. If the company
pays out one-half of its net income as dividends, the pro forma income statement and balance sheet
will look like this:

Pro forma income statement Pro forma balance sheet

Sales $26,450.00 Assets $18,170.0 Debt $ 5,200.00
0
Costs 19,205.00 Equity 14,222.50
Net income $ 7,245.00 Total $18,170.0 Total $19,422.50
0

Dividends $3,622.50
Add. to RE $3,622.50

Note that the balance sheet does not balance. This is due to EFN. The EFN for this company is:

EFN = Total assets – Total liabilities and equity

EFN = $18,170 – 19,422.50
EFN = –$1,252.50

3. An increase of sales to $7,424 is an increase of:

Sales increase = ($7,424 – 6,300) / $6,300

Sales increase = .18 or 18%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like
this:

Pro forma income statement Pro forma balance sheet

Sales $ 7,434 Assets $ 21,594 Debt $ 12,400
Costs 4,590 Equity 8,744
Net income $ 2,844 Total $ 21,594 Total $ 21,144

If no dividends are paid, the equity account will increase by the net income, so:

Equity = $5,900 + 2,844

Equity = $8,744

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $21,594 – 21,144 = $450

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4|Page
4. An increase of sales to $21,840 is an increase of:

Sales increase = ($21,840 – 19,500) / $19,500

Sales increase = .12 or 12%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like
this:

Pro forma income statement Pro forma balance sheet

Sales $ 21,840 Assets $109,760 Debt $52,500
Costs 16,800 Equity 79,208
EBIT 5,040 Total $109,760 Total $99,456
Taxes (40%) 2,016
Net income $ 3,024

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times
net income, or:

Dividends = ($1,400 / $2,700)($3,024)

Dividends = $1,568

The addition to retained earnings is:

Addition to retained earnings = $3,024 – 1,568

Addition to retained earnings = $1,456

And the new equity balance is:

Equity = $45,500 + 1,456

Equity = $46,956

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $109,760 – 99,456
EFN = $10,304

5. Assuming costs and assets increase proportionally, the pro forma financial statements will look like
this:
Pro forma income statement Pro forma balance sheet
Sales $4,830.00 CA $4,140.00 CL $2,145.00
Costs 3,795.00 FA 9,085.00 LTD 3,650.00
Taxable income $1,035.00 Equity 6,159.86
Taxes (34%) 351.90 TA $13,225.00 Total D&E $12,224.86
Net income $ 683.10

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 The payout ratio is 40 percent, so dividends will be:

Dividends = 0.40($683.10)
Dividends = $273.24

The addition to retained earnings is:

Addition to retained earnings = $683.10 – 273.24

Addition to retained earnings = $409.86

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $13,225 – 12,224.86
EFN = $1,000.14

6. To calculate the internal growth rate, we first need to calculate the ROA, which is:

ROA = NI / TA
ROA = $2,262 / $39,150
ROA = .0578 or 5.78%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – .30
b = .70

Now we can use the internal growth rate equation to get:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [0.0578(.70)] / [1 – 0.0578(.70)]
Internal growth rate = .0421 or 4.21%

7. To calculate the sustainable growth rate, we first need to calculate the ROE, which is:

ROE = NI / TE
ROE = $2,262 / $21,650
ROE = .1045 or 10.45%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – .30
b = .70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.1045(.70)] / [1 – 0.1045(.70)]
Sustainable growth rate = .0789 or 7.89%

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8. The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable
growth rate, we first need to calculate the ROE, which is:

ROE = NI / TE
ROE = $8,910 / $56,000
ROE = .1591 or 15.91%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – .30
b = .70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1591(.70)] / [1 – .1591(.70)]
Sustainable growth rate = .1253 or 12.53%

So, the maximum dollar increase in sales is:

Maximum increase in sales = $42,000(.1253)

Maximum increase in sales = $5,264.03

9. Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement
will look like this:

HEIR JORDAN CORPORATION

Pro Forma Income Statement
Sales $45,600.00
Costs 22,080.00
Taxable income $23,520.00
Taxes (34%) 7,996.80
Net income $ 15,523.20

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times
net income, or:

Dividends = ($5,200/$12,936)($15,523.20)
Dividends = $6,240.00

And the addition to retained earnings will be:

Addition to retained earnings = $15,523.20 – 6,240

Addition to retained earnings = $9,283.20

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10. Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes
payable, total current liabilities, long-term debt, and all equity accounts do not vary directly with
sales.

HEIR JORDAN CORPORATION

Balance Sheet
($) (%) ($) (%)

Assets Liabilities and Owners’ Equity

Current assets Current liabilities
Cash $ 3,050 8.03 Accounts payable $ 1,300 3.42
Accounts receivable 6,900 18.16 Notes payable 6,800 n/a
Inventory 7,600 20.00 Total $ 8,100 n/a
Total $ 17,550 46.18 Long-term debt 25,000 n/a
Fixed assets Owners’ equity
Net plant and Common stock and
equipment 34,500 90.79 paid-in surplus $15,000 n/a
Retained earnings 3,950 n/a
Total $18,950 n/a
Total liabilities and owners’
Total assets $52,050 136.97 equity $52,050 n/a

11. Assuming costs vary with sales and a 15 percent increase in sales, the pro forma income statement
will look like this:

HEIR JORDAN CORPORATION

Pro Forma Income Statement
Sales $43,700.00
Costs 21,160.00
Taxable income $22,540.00
Taxes (34%) 7,663.60
Net income $ 14,876.40

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times
net income, or:

Dividends = ($5,200/$12,936)($14,876.40)
Dividends = $5,980.00

And the addition to retained earnings will be:

Addition to retained earnings = $14,876.40 – 5,980

Addition to retained earnings = $8,896.40

The new accumulated retained earnings on the pro forma balance sheet will be:

New accumulated retained earnings = $3,950 + 8,896.40

New accumulated retained earnings = $12,846.40

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 The pro forma balance sheet will look like this:

HEIR JORDAN CORPORATION

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities
Cash $ 3,507.50 Accounts payable $ 1,495.00
Accounts receivable 7,935.00 Notes payable 6,800.00
Inventory 8,740.00 Total $ 8,295.00
Total $20,182.50 Long-term debt 25,000.00
Fixed assets
Net plant and Owners’ equity
equipment 39.675.00 Common stock and
paid-in surplus $ 15,000.00
Retained earnings 12,846.40
Total $ 27,846.40
Total liabilities and owners’
Total assets $ 59,857.50 equity $ 61,141.40

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $59,857.50 – 61,141.40
EFN = –$1,283.90

12. We need to calculate the retention ratio to calculate the internal growth rate. The retention ratio is:

b = 1 – .20
b = .80

Now we can use the internal growth rate equation to get:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [.08(.80)] / [1 – .08(.80)]
Internal growth rate = .0684 or 6.84%

13. We need to calculate the retention ratio to calculate the sustainable growth rate. The retention ratio
is:

b = 1 – .25
b = .75

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.15(.75)] / [1 – .15(.75)]
Sustainable growth rate = .1268 or 12.68%

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14. We first must calculate the ROE to calculate the sustainable growth rate. To do this we must realize
two other relationships. The total asset turnover is the inverse of the capital intensity ratio, and the
equity multiplier is 1 + D/E. Using these relationships, we get:

ROE = (PM)(TAT)(EM)
ROE = (.082)(1/.75)(1 + .40)
ROE = .1531 or 15.31%

The plowback ratio is one minus the dividend payout ratio, so:

b = 1 – ($12,000 / $43,000)
b = .7209

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1531(.7209)] / [1 – .1531(.7209)]
Sustainable growth rate = .1240 or 12.40%

15. We must first calculate the ROE using the DuPont ratio to calculate the sustainable growth rate. The
ROE is:

ROE = (PM)(TAT)(EM)
ROE = (.078)(2.50)(1.80)
ROE = .3510 or 35.10%

The plowback ratio is one minus the dividend payout ratio, so:

b = 1 – .60
b = .40

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.3510(.40)] / [1 – .3510(.40)]
Sustainable growth rate = .1633 or 16.33%

Intermediate

16. To determine full capacity sales, we divide the current sales by the capacity the company is currently
using, so:

Full capacity sales = $550,000 / .95

Full capacity sales = $578,947

The maximum sales growth is the full capacity sales divided by the current sales, so:

Maximum sales growth = ($578,947 / $550,000) – 1

Maximum sales growth = .0526 or 5.26%

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17. To find the new level of fixed assets, we need to find the current percentage of fixed assets to full
capacity sales. Doing so, we find:

Fixed assets / Full capacity sales = $440,000 / $578,947

Fixed assets / Full capacity sales = .76

Next, we calculate the total dollar amount of fixed assets needed at the new sales figure.

Total fixed assets = .76($630,000)

Total fixed assets = $478,800

The new fixed assets necessary is the total fixed assets at the new sales figure minus the current level
of fixed assts.

New fixed assets = $478,800 – 440,000

New fixed assets = $38,800

18. We have all the variables to calculate ROE using the DuPont identity except the profit margin. If we
find ROE, we can solve the DuPont identity for profit margin. We can calculate ROE from the
sustainable growth rate equation. For this equation we need the retention ratio, so:

b = 1 – .30
b = .70

Using the sustainable growth rate equation and solving for ROE, we get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

.12 = [ROE(.70)] / [1 – ROE(.70)]
ROE = .1531 or 15.31%

Now we can use the DuPont identity to find the profit margin as:

ROE = PM(TAT)(EM)
.1531 = PM(1 / 0.75)(1 + 1.20)
PM = (.1531) / [(1 / 0.75)(2.20)]
PM = .0522 or 5.22%

19. We have all the variables to calculate ROE using the DuPont identity except the equity multiplier.
Remember that the equity multiplier is one plus the debt-equity ratio. If we find ROE, we can solve
the DuPont identity for equity multiplier, then the debt-equity ratio. We can calculate ROE from the
sustainable growth rate equation. For this equation we need the retention ratio, so:

b = 1 – .30
b = .70

Using the sustainable growth rate equation and solving for ROE, we get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

.115 = [ROE(.70)] / [1 – ROE(.70)]
ROE = .1473 or 14.73%

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 Now we can use the DuPont identity to find the equity multiplier as:

ROE = PM(TAT)(EM)
.1473 = (.062)(1 / .60)EM
EM = (.1473)(.60) / .062
EM = 1.43

So, the D/E ratio is:

D/E = EM – 1
D/E = 1.43 – 1
D/E = 0.43

20. We are given the profit margin. Remember that:

ROA = PM(TAT)

We can calculate the ROA from the internal growth rate formula, and then use the ROA in this
equation to find the total asset turnover. The retention ratio is:

b = 1 – .25
b = .75

Using the internal growth rate equation to find the ROA, we get:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

.07 = [ROA(.75)] / [1 – ROA(.75)]
ROA = .0872 or 8.72%

Plugging ROA and PM into the equation we began with and solving for TAT, we get:

ROA = (PM)(TAT)
.0872 = .05(PM)
TAT = .0872 / .05
TAT = 1.74 times

21. We should begin by calculating the D/E ratio. We calculate the D/E ratio as follows:

Total debt ratio = .65 = TD / TA

Inverting both sides we get:

1 / .65 = TA / TD

Next, we need to recognize that

TA / TD = 1 + TE / TD

Substituting this into the previous equation, we get:

1 / .65 = 1 + TE /TD

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 Subtract 1 (one) from both sides and inverting again, we get:

D/E = 1 / [(1 / .65) – 1]

D/E = 1.86

With the D/E ratio, we can calculate the EM and solve for ROE using the DuPont identity:

ROE = (PM)(TAT)(EM)
ROE = (.048)(1.25)(1 + 1.86)
ROE = .1714 or 17.14%

Now we can calculate the retention ratio as:

b = 1 – .30
b = .70

Finally, putting all the numbers we have calculated into the sustainable growth rate equation, we get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1714(.70)] / [1 – .1714(.70)]
Sustainable growth rate = .1364 or 13.64%

22. To calculate the sustainable growth rate, we first must calculate the retention ratio and ROE. The
retention ratio is:

b = 1 – $9,300 / $17,500
b = .4686

And the ROE is:

ROE = $17,500 / $58,000

ROE = .3017 or 30.17%

So, the sustainable growth rate is:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.3017(.4686)] / [1 – .3017(.4686)]
Sustainable growth rate = .1647 or 16.47%

If the company grows at the sustainable growth rate, the new level of total assets is:

New TA = 1.1647($86,000 + 58,000) = $167,710.84

To find the new level of debt in the company’s balance sheet, we take the percentage of debt in the
capital structure times the new level of total assets. The additional borrowing will be the new level of
debt minus the current level of debt. So:

New TD = [D / (D + E)](TA)
New TD = [$86,000 / ($86,000 + 58,000)]($167,710.84)
New TD = $100,160.64

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 And the additional borrowing will be:

Additional borrowing = $100,160.04 – 86,000

Additional borrowing = $14,160.64

The growth rate that can be supported with no outside financing is the internal growth rate. To
calculate the internal growth rate, we first need the ROA, which is:

ROA = $17,500 / ($86,000 + 58,000)

ROA = .1215 or 12.15%

This means the internal growth rate is:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [.1215(.4686)] / [1 – .1215(.4686)]
Internal growth rate = .0604 or 6.04%

23. 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 = $19,000 – 2,500
Retained earnings = $16,500

So, the equity at the end of the year was:

Ending equity = $135,000 + 16,500

Ending equity = $151,500

The ROE based on the end of period equity is:

ROE = $19,000 / $151,500

ROE = .1254 or 12.54%

The plowback ratio is:

Plowback ratio = Addition to retained earnings/NI

Plowback ratio = $16,500 / $19,000
Plowback ratio = .8684 or 86.84%

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 = [.1254(.8684)] / [1 – .1254(.8684)]
Sustainable growth rate = .1222 or 12.22%

The ROE based on the beginning of period equity is

ROE = $16,500 / $135,000

ROE = .1407 or 14.07%

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 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 = .1407 × .8684
Sustainable growth rate = .1222 or 12.22%

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 = .1254 × .8684
Sustainable growth rate = .1089 or 10.89%

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.

24. The ROA using end of period assets is:

ROA = $19,000 / $250,000

ROA = .0760 or 7.60%

The beginning of period assets had to have been the ending assets minus the addition to retained
earnings, so:

Beginning assets = Ending assets – Addition to retained earnings

Beginning assets = $250,000 – 16,500
Beginning assets = $233,500

And the ROA using beginning of period assets is:

ROA = $19,000 / $233,500

ROA = .0814 or 8.14%

Using the internal growth rate equation presented in the text, we get:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [.0814(.8684)] / [1 – .0814(.8684)]
Internal growth rate = .0707 or 7.07%

Using the formula ROA × b, and end of period assets:

Internal growth rate = .0760 × .8684

Internal growth rate = .0660 or 6.60%

Using the formula ROA × b, and beginning of period assets:

Internal growth rate = .0814 × .8684

Internal growth rate = .0707 or 7.07%

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25. 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
Costs 867,600
Other expenses 22,800
EBIT $ 224,400
Interest 14,000
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

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 30,360 Accounts payable $ 81,600
Accounts receivable 48,840 Notes payable 17,000
Inventory 104,280 Total $ 98,600
Total $ 183,480 Long-term debt 158,000
Fixed assets
Net plant and Owners’ equity
equipment 495,600 Common stock and
paid-in surplus $ 140,000
Retained earnings 278,632
Total $ 418,632
Total liabilities and owners’
Total assets $ 679,080 equity $ 675,232

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 So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $679,080 – 675,232
EFN = $3,848

26. First, we need to calculate full capacity sales, which is:

Full capacity sales = $929,000 / .80

Full capacity sales = $1,161,250

The full capacity ratio at full capacity sales is:

Full capacity ratio = Fixed assets / Full capacity sales

Full capacity ratio = $413,000 / $1,161,250
Full capacity ratio = .35565

The fixed assets required at full capacity sales is the full capacity ratio times the projected sales
level:

Total fixed assets = .35565($1,161,250) = $396,480

So, EFN is:

EFN = ($183,480 + 396,480) – $675,232 = –$95,272

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

27. 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

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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 CL + 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

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 30,360 Accounts payable $ 81,600
Accounts receivable 44,400 Notes payable 17,000
Inventory 104,280 Total $ 98,600
Total $ 183,480 Long-term debt 216,444
Fixed assets
Net plant and Owners’ equity
equipment 495,600 Common stock and
paid-in surplus $ 140,000
Retained earnings 278,632
Total $ 418,632
Total liabilities and owners’
Total assets $ 697,080 equity $ 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 – 697,080 = $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:

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 MOOSE TOURS INC.
Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities
Cash $ 30,360 Accounts payable $ 81,600
Excess cash 54,596
Accounts receivable 44,400 Notes payable 17,000
Inventory 104,280 Total $ 98,600
Total $ 238,076 Long-term debt 216,444
Fixed assets
Net plant and Owners’ equity
equipment 495,600 Common stock and
paid-in surplus $ 140,000
Retained earnings 278,632
Total $ 418,632
Total liabilities and owners’
Total assets $ 733,676 equity $ 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($697,080) = $291,600

Equity needed = .57($697,080) = $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:

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 MOOSE TOURS INC.
Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 30,360 Accounts payable $ 81,600
Accounts receivable 44,400 Notes payable 17,000
Inventory 104,280 Total $ 98,600
Total $ 183,480 Long-term debt 193,000
Fixed assets
Net plant and Owners’ equity
equipment 495,600 Common stock and
paid-in surplus $ 140,000
Retained earnings 247,480
Total $ 387,480
Total liabilities and owners’
Total assets $ 697,080 equity $ 697,080

Challenge

28. The pro forma income statements for all three growth rates will be:

MOOSE TOURS INC.

Pro Forma Income Statement

15 % Sales 20% Sales 25% Sales

Growth Growth Growth
Sales $1,068,350 $1,114,800 $1,161,250
Costs 831,450 867,600 903,750
Other expenses 21,850 22,800 23,750
EBIT $215,050 $224,400 $233,750
Interest 14,000 14,000 14,000
Taxable income $201,050 $210,400 $219,750
Taxes (35%) 70,368 73,640 76,913
Net income $130,683 $136,760 $142,838

Dividends $39,205 $41,028 $42,851

Add to RE 91,478 95,732 99,986

We will calculate the EFN for the 15 percent growth rate first. Assuming the payout ratio is constant,
the dividends paid will be:

Dividends = ($33,735/$112,450)($130,683)
Dividends = $39,205

And the addition to retained earnings will be:

Addition to retained earnings = $130,683 – 39,205

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 Addition to retained earnings = $91,478

The new retained earnings on the pro forma balance sheet will be:

New retained earnings = $182,900 + 91,478

New retained earnings = $274,378

The pro forma balance sheet will look like this:

15% Sales Growth:

MOOSE TOURS INC.
Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 29,095 Accounts payable $ 78,200
Accounts receivable 46,805 Notes payable 17,000
Inventory 99,935 Total $ 95,200
Total $ 175,835 Long-term debt $ 158,000
Fixed assets
Net plant and Owners’ equity
equipment 474,950 Common stock and
paid-in surplus $ 140,000
Retained earnings 274,378
Total $ 414,378
Total liabilities and owners’
Total assets $ 650,785 equity $ 667,578

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $650,785 – 667,578
EFN = –$16,793

At a 20 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

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

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 The pro forma balance sheet will look like this:

20% Sales Growth:

MOOSE TOURS INC.

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 30,360 Accounts payable $ 81,600
Accounts receivable 48,840 Notes payable 17,000
Inventory 104,280 Total $ 98,600
Total $ 183,480 Long-term debt $ 158,000
Fixed assets
Net plant and Owners’ equity
equipment 495,600 Common stock and
paid-in surplus $ 140,000
Retained earnings 278,632
Total $ 418,632
Total liabilities and owners’
Total assets $ 679,080 equity $ 675,232

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $679,080 – 675,232
EFN = $3,848

At a 25 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

Dividends = ($33,735/$112,450)($142,838)
Dividends = $42,851

And the addition to retained earnings will be:

Addition to retained earnings = $142,838 – 42,851

Addition to retained earnings = $99,986

The new retained earnings on the pro forma balance sheet will be:

New retained earnings = $182,900 + 99,986

New retained earnings = $282,886

The pro forma balance sheet will look like this:

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 25% Sales Growth:
MOOSE TOURS INC.
Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 31,625 Accounts payable $ 85,000
Accounts receivable 50,875 Notes payable 17,000
Inventory 108,625 Total $ 102,000
Total $ 191,125 Long-term debt $ 158,000
Fixed assets
Net plant and Owners’ equity
equipment 516,250 Common stock and
paid-in surplus $ 140,000
Retained earnings 282,886
Total $ 422,886
Total liabilities and owners’
Total assets $ 707,375 equity $ 682,886

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $707,375 – 682,886
EFN = $24,889

29. The pro forma income statements for all three growth rates will be:

MOOSE TOURS INC.

Pro Forma Income Statement
20% Sales 30% Sales 35% Sales
Growth Growth Growth
Sales $1,114,800 $1,207,700 $1,254,150
Costs 867,600 939,900 976,050
Other expenses 22,800 24,700 25,650
EBIT $224,400 $243,100 $252,450
Interest 14,000 14,000 14,000
Taxable income $210,400 $229,100 $238,450
Taxes (35%) 73,640 80,185 83,458
Net income $136,760 $148,915 $154,993

Dividends $41,028 $44,675 $46,498

Add to RE 95,732 104,241 108,495

At a 30 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

Dividends = ($30,810/$102,700)($135,948)
Dividends = $40,784

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 And the addition to retained earnings will be:

Addition to retained earnings = $135,948 – 40,784

Addition to retained earnings = $104,241

The new addition to retained earnings on the pro forma balance sheet will be:

New addition to retained earnings = $182,900 + 104,241

New addition to retained earnings = $287,141
The new total debt will be:

New total debt = .7556($427,141)

New total debt = $321,447

So, the new long-term debt will be the new total debt minus the new short-term debt, or:

New long-term debt = $321,447 – 105,400

New long-term debt = $58,047

The pro forma balance sheet will look like this:

Sales growth rate = 30% and debt/equity ratio = .7526:

MOOSE TOURS INC.

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 32,890 Accounts payable $ 88,400
Accounts receivable 52,910 Notes payable 17,000
Inventory 112,970 Total $ 105,400
Total $ 198,770 Long-term debt 216,047
Fixed assets
Net plant and Owners’ equity
equipment 536,900 Common stock and
paid-in surplus $ 140,000
Retained earnings 287,141
Total $ 427,141
Total liabilities and owners’
Total assets $ 735,670 equity $ 748,587

So the excess debt raised is:

Excess debt = $748,587 – 735,670

Excess debt = $12,917

At a 35 percent growth rate, and assuming the payout ratio is constant, the dividends paid will be:

Dividends = ($30,810/$102,700)($154,993)
Dividends = $46,498

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 And the addition to retained earnings will be:

Addition to retained earnings = $154,993 – 46,498

Addition to retained earnings = $108,495

The new retained earnings on the pro forma balance sheet will be:

New retained earnings = $182,900 + 108,495

New retained earnings = $291,395

The new total debt will be:

New total debt = .75255($431,395)

New total debt = $324,648

So, the new long-term debt will be the new total debt minus the new short-term debt, or:

New long-term debt = $324,648 – 108,800

New long-term debt = $215,848

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 Sales growth rate = 35% and debt/equity ratio = .75255:

MOOSE TOURS INC.

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 34,155 Accounts payable $ 91,800
Accounts receivable 54,945 Notes payable 17,000
Inventory 117,315 Total $ 108,800
Total $ 206,415 Long-term debt $ 215,848
Fixed assets
Net plant and Owners’ equity
equipment 557,550 Common stock and
paid-in surplus $ 140,000
Retained earnings 291,395
Total $ 431,395
Total liabilities and owners’
Total assets $ 763,965 equity $ 756,043

So the excess debt raised is:

Excess debt = $756,043 – 763,965

Excess debt = –$7,922

At a 35 percent growth rate, the firm will need funds in the amount of $7,922 in addition to the
external debt already raised. So, the EFN will be:

EFN = $57,848 + 7,922

EFN = $65,770

30. We must need the ROE to calculate the sustainable growth rate. The ROE is:

ROE = (PM)(TAT)(EM)
ROE = (.067)(1 / 1.35)(1 + 0.30)
ROE = .0645 or 6.45%

Now we can use the sustainable growth rate equation to find the retention ratio as:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = .12 = [.0645(b)] / [1 – .0645(b)
b = 1.66

This implies the payout ratio is:

Payout ratio = 1 – b
Payout ratio = 1 – 1.66
Payout ratio = –0.66

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 This is a negative dividend payout ratio of 66 percent, which is impossible. The growth rate is not
consistent with the other constraints. The lowest possible payout rate is 0, which corresponds to
retention ratio of 1, or total earnings retention.

The maximum sustainable growth rate for this company is:

Maximum sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Maximum sustainable growth rate = [.0645(1)] / [1 – .0645(1)]
Maximum sustainable growth rate = .0690 or 6.90%

31. We know that EFN is:

EFN = Increase in assets – Addition to retained earnings

The increase in assets is the beginning assets times the growth rate, so:

Increase in assets = A  g

The addition to retained earnings next year is the current net income times the retention ratio, times
one plus the growth rate, so:

Addition to retained earnings = (NI  b)(1 + g)

And rearranging the profit margin to solve for net income, we get:

NI = PM(S)

Substituting the last three equations into the EFN equation we started with and rearranging, we get:

EFN = A(g) – PM(S)b(1 + g)

EFN = A(g) – PM(S)b – [PM(S)b]g
EFN = – PM(S)b + [A – PM(S)b]g

32. We start with the EFN equation we derived in Problem 31 and set it equal to zero:

EFN = 0 = – PM(S)b + [A – PM(S)b]g

Substituting the rearranged profit margin equation into the internal growth rate equation, we have:

Internal growth rate = [PM(S)b ] / [A – PM(S)b]

Since:

ROA = NI / A
ROA = PM(S) / A

We can substitute this into the internal growth rate equation and divide both the numerator and
denominator by A. This gives:

Internal growth rate = {[PM(S)b] / A} / {[A – PM(S)b] / A}

Internal growth rate = b(ROA) / [1 – b(ROA)]

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 To derive the sustainable growth rate, we must realize that to maintain a constant D/E ratio with no
external equity financing, EFN must equal the addition to retained earnings times the D/E ratio:

EFN = (D/E)[PM(S)b(1 + g)]

EFN = A(g) – PM(S)b(1 + g)

Solving for g and then dividing numerator and denominator by A:

Sustainable growth rate = PM(S)b(1 + D/E) / [A – PM(S)b(1 + D/E )]

Sustainable growth rate = [ROA(1 + D/E )b] / [1 – ROA(1 + D/E )b]
Sustainable growth rate = b(ROE) / [1 – b(ROE)]

33. In the following derivations, the subscript “E” refers to end of period numbers, and the subscript “B”
refers to beginning of period numbers. TE is total equity and TA is total assets.

For the sustainable growth rate:

Sustainable growth rate = (ROEE × b) / (1 – ROEE × b)

Sustainable growth rate = (NI/TEE × b) / (1 – NI/TEE × b)

We multiply this equation by:

(TEE / TEE)

Sustainable growth rate = (NI / TEE × b) / (1 – NI / TEE × b) × (TEE / TEE)

Sustainable growth rate = (NI × b) / (TEE – NI × b)

Recognize that the numerator is equal to beginning of period equity, that is:

(TEE – NI × b) = TEB

Substituting this into the previous equation, we get:

Sustainable rate = (NI × b) / TEB

Which is equivalent to:

Sustainable rate = (NI / TEB) × b

Since ROEB = NI / TEB

The sustainable growth rate equation is:

Sustainable growth rate = ROEB × b

For the internal growth rate:

Internal growth rate = (ROAE × b) / (1 – ROAE × b)

Internal growth rate = (NI / TAE × b) / (1 – NI / TAE × b)

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 We multiply this equation by:

(TAE / TAE)

Internal growth rate = (NI / TAE × b) / (1 – NI / TAE × b) × (TAE / TAE)

Internal growth rate = (NI × b) / (TAE – NI × b)

Recognize that the numerator is equal to beginning of period assets, that is:

(TAE – NI × b) = TAB

Substituting this into the previous equation, we get:

Internal growth rate = (NI × b) / TAB

Which is equivalent to:

Internal growth rate = (NI / TAB) × b

Since ROAB = NI / TAB

The internal growth rate equation is:

Internal growth rate = ROAB × b

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