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Question #1 Question #2
All dollar values in $millions Year-zero Percentage of Year-One Year-One
of Sales
Income Statement
Net Sales $500.00 100.0%
Cost of Goods Sold ($400.00) 80.0%
General & Administrative Expenses ($52.00) 10.4%
        Earnings before interest and taxes $48.00 9.6%
Interest expense ($8.00) n.a.
        Earnings before taxes $40.00 n.a.
Taxes  (35%) ($14.00) n.a.
Net income $26.00 n.a.
Dividends (30%) ($7.80) n.a.
       Addition to retained earnings $18.20 n.a.
Balance Sheet
Cash $10.00 2.0%
Accounts receivable $85.00 17.0%
Inventory $100.00 20.0%
     Current assets $195.00 n.a.
Net fixed assets $150.00 30.0%
      Total Assets $345.00 n.a.
Accounts payable $65.00 13.0%
Notes payable (short term debt) $10.00 n.a.
      Current liabilities $75.00 n.a.
Long-term debt $72.00 n.a.
      Total Liabilities $147.00
Common stock $150.00 n.a.
Retained Earnings $48.00 n.a.
      Total Equity $198.00
Total Liabilities & Owners’ Equity $345.00 n.a.

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It is now late Year-Zero and you have just been handed the proformas for Year- Zero. You have a fair degree of confidence in these numbers since the fiscal year is about to finish and most of the numbers are already in. These proformas appear on the next page. The task you have been assigned is to forecast the statements for Year-One. In order to carry out this task, you have obtained the following relevant information.

The firm is forecasting a growth rate in sales of 50% over Year-Zero sales. In conversations with several old hands at the firm, you have determined that the “Cost of goods sold” item, which includes depreciation, has historically increased in a proportionate manner with sales, as have items like: Cash, Accounts Receivable, Inventory, Accounts Payable, Selling and Administrative Expenses, and Accrued Wages and Taxes. The cash from depreciation of existing fixed assets has historically been used to update those fixed assets, and so cannot be diverted to “new capital”. This implies that if no new fixed assets are purchased, net fixed assets for Year-One would remain the same number as in Year-Zero.1 To accommodate increased production for the new growth in sales, your boss has directed you to assume that the net fixed assets for Year-One will grow proportionately with sales. Your boss has also told you that the firm desires to maintain a debt ratio2 of 0.43 and a current ratio3 of 2.60 since these ratios have been deemed to be optimal for firms in your industry. The tax rate is assumed to be 35%, and the dividend payout ratio4 is to be maintained at 30% (as it was last year). If new shares are to be issued, it is assumed that these new shares will also receive the dividend. For purposes of interest payment computations, you have been told to assume that interest must be computed for the whole of Year-One, even if the debt is raised on a gradual basis over the year. Specifically, you are to assume that the debt is to be raised as soon as possible in Year-One, and that interest will accrue on this new debt for the whole of Year-One.

A call to your investment bankers has revealed the following information: Interest rates on new short term debt will be 9% per year and on long term debt, 11%. The entire amount of $10 Million in notes payable as of YEAR0 fiscal year-end will be refinanced at the new short term debt interest rate of 9%. The long term bonds of $72 million carry a coupon rate of 10%, and this will not change for YEAR1. However, new long term debt will cost the firm 11% per year. For purposes of new equity issuance, you have been told that a domestic insurance company located in NJ will buy new shares from your firm. Since this will be a private placement of equity, no SEC registration will be required, and hence the stock offering can be completed expeditiously.

1. What is the Additional External Funding Needed to achieve the projected 50% growth rate (use “Solver” to change the Notes Payable, Long-term debt, and common equity to make the balance sheet balanced)? Briefly discuss how you calculate the final answer in light of the forecasted changes to each of the external financing sources (i.e. show the final step of your calculation).

2. If the firm is reluctant to use additional external financing due to the tight credit market and equity market, what is the maximum growth rate in sales that you forecast for the firm? As a financial consultant, what is your advice on its dividend payout policy, if the firm wants to achieve a higher growth rate?
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