Question 4-1:

A company is forecasting an increase in sales and is using the AFN model to forecast the additional capital that they need to raise. Which of the following factors are likely to
increase the additional funds needed (AFN)?

a. The company has a lot of excess capacity.

b. The company has a high dividend payout ratio.
c. The company has a lot of spontaneous liabilities that increase as sales increase.
d. The company has a high profit margin.
e. All of the answers above are correct.

Question 4-2:
Jill's Wigs Inc. had the following balance sheet last year:

Cash $ 800 Accounts payable $ 350

Accounts receivable 450 Accrued wages 150
Inventory 950 Notes payable 2,000
Net fixed assets 34,000 Mortgage 26,500
Common stock 3,200
Retained earnings 4,000
Total liabilities
. Total assets $36,200 and equity $36,200
======= =======

Jill has just invented a non-slip wig for men which she expects will cause sales to double, increasing net income to $1,000. She feels that she can handle the increase without
adding any fixed assets. (1) Will Jill need any outside capital if she pays no dividends? (2) If so, how much?

a. No; zero
b. Yes; $7,700
c. Yes; $1,700
d. Yes; $700
e. No; there will be a $700 surplus.

Question 4-3:
The constant ratio method produces accurate results unless which of the following conditions is (are) present?

a. Fixed assets are "lumpy."

b. Strong economies of scale are present.
c. Excess capacity exists because of a temporary recession.
d. Answers a, b, and c all make the constant ratio method inaccurate.
e. Answers a and c make the constant ratio method inaccurate, but, as the text explains, the assumption of increasing economies of scale is built into the constant ratio method.
SUGGESTED ANSWER

Answer 4-1:
b. The company has a high dividend payout ratio.
Additional funds needed

Only answer b will increase AFN; the other statements will decrease
AFN.

Answer 4-2:
d. Yes; $700
Additional funds needed

Balance Sheet solution:

Pro Forma Balance Sheet
Cash $ 1,600 Accounts payable $ 700
Accounts receivable 900 Accrued wages 300
Inventory 1,900 Notes payable 2,000
Net fixed assets 34,000 Mortgage 26,500
Common stock 3,200
Retained earnings 5,000
Total liabilities
. Total assets $38,400 & equity $37,700
======= =======

AFN = $38,400 - $37,700 = $700.

Formula solution:
S = S; MS = $1,000.
. A* L*
.AFN = (S) - (S) - MS(1 - d) = $2,200 - $500 - $1,000(1) =
S S
$700.

Answer 4-3:
d. Answers a, b, and c all make the constant ratio method inaccurate.
Constant ratio method
 Additional Funds Needed

Additional funds needed (AFN) is the amount of money a company must raise from external sources to finance the increase in assets required to support
increased level of sales. Additional funds needed (AFN) is also called external financing needed.

Additional funds needed method of financial planning assumes that the company's financial ratios do not change. In response to an increase in sales, a company
must increase its assets, such as property, plant and equipment, inventories, accounts receivable, etc. Part of this increase in offset by spontaneous increase in
liabilities such as accounts payable, taxes, etc., and part is offset by increase in retained earnings.

Formula and Calculation

Additional funds needed (AFN) is calculated as the excess of required increase in assets over the increase in liabilities and increase in retained earnings.

S S
Additional Funds Needed = Ao Lo S1 PM b
So So

Where,

Ao = current level of assets

S/So = percentage increase in sales i.e. change in sales divided by current sales
Lo = current level of liabilities

S1 = new level of sales

PM = profit margin
b = retention rate = 1 payout rate

A negative figure for additional funds needed means that there is a surplus of capital.

Example

TransWorld Inc. runs a shipping business and has forecasted a 10% increase in sales over 20Y3. Its assets and liabilities at the end of 20Y2 amounted to $25
billion and $17 billion respectively. Sales for the period were $30 billion and it earned a 4% profit margin. It reinvests 40% of its net income and pays out the rest
to its shareholders. Calculate additional funds needed.
Solution

Additional funds needed = increase in assets increase in liabilities increase in retained earnings

Increase in assets = 20Y2 assets sales growth rate = $25 billion 10% = $2.5 billion

Spontaneous increase in liabilities = 20Y2 liabilities sales growth rate = $17 billion 10% = $1.7 billion

Increase in retained earnings = 20Y3 sales profit margin retention rate = 20Y2 sales (1 + sales growth rate) profit margin retention rate = $30 billion (1
+ 10%)4%40% = $0.528 billion

Plugging all the figures gives us a figure of $0.272 billion.

Additional funds needed = $2.5 billion $1.7 billion $0.528 billion = $0.272 billion

TransWorld must raise $272 million to finance the increased level of sales.