# Finman Part 2 lecture 1 (internet) solution to problems

```PROBLEMS
Planning Assumptions – Example 4.1 (page 135)
1. The Lineberry Golf Cart Co. sold 7,400 carts this year at an average unit price of
\$3,000. 50 days of sales remained uncollected in accounts receivable at the end of the
year. The firm produced the carts at a 42% cost ratio (COGS/Revenue) and had three
months of inventory on hand at year end (3/12 of the year’s COGS).
The golf business is booming and management plans a 10% increase in unit sales
despite a 5% price increase. The firm has programs in place to improve production
efficiency, inventory management, and the effectiveness of collections efforts. It is
assumed that these programs will decrease the cost ratio to 40%, lower year end
inventory to 2 months, and lower year end receivables to 40 days of sales.
Compute Lineberry’s revenue, COGS (cost of goods sold) and gross margin as well as
ending receivables and inventory for this year and next year’s plan. Calculate using a
360 day year and assume sales are evenly distributed over the year.
SOLUTION:
This Year Next Year’s Plan
Units 7,400 7,400 x 1.1 = 8,140
Price x \$3,000 \$3,000 x 1.05 = x \$3,150
Units x Price = Revenue
Revenue = \$22,200,000 \$25,641,000
Revenue x Cost Ratio = COGS
Cost ratio x.42 x .40
COGS \$9,324,000 \$10,256,400
Revenue – COGS = Gross Margin
Gross Margin \$12,876,000 \$15,384,600
(Days sales in A/R ÷ 360) x Revenue = A/R
A/R (50/360) x \$22,200,000 = \$3,083,333 (40/360) x \$25,641,000 = \$2,849,000
(Months Cost in INV / 12) x COGS = Inventory
COGS (3/12) x \$9,324,000 = \$2,331,000 (2/12) x \$10,256,400 = \$1,709,400
The Debt/Interest Planning Problem – Example 4.2 (page 137)
2. The Cambridge Cartage Company has partially completed its forecast of next year's financial
statements as follows.
FINANCIAL PLAN
CAMBRIDGE CARTAGE COMPANY
(\$000)
INCOME STATEMENT BALANCE SHEET
NEXT YEAR
NEXT YEAR Beginning Ending
Rev \$17,220 ASSETS
Cost/Exp 14,120 Total Assets \$12,540 \$18,330
EBIT \$ 3,100 LIABILITIES & EQUITY
Interest ? Current Liabs \$ 410 \$ 680
EBT ? Debt \$ 5,630 ?
Tax ? Equity \$ 6,500 ?__
EAT ? Total L&E \$12,540 \$18,330
The firm pays interest at 10% on all borrowings and pays a combined state and federal tax rate of
40%. Complete the forecasted income statement and balance sheet. Begin by guessing at interest
expense as 10% of beginning debt.
SOLUTION: The iterative procedure results in the following:
EBIT \$ 3,100 LIABILITIES & EQUITY
Interest \$ 769 Current Liabs \$ 410 \$ 680
EBT \$ 2,331 Debt \$ 5,630 \$ 9,751
Tax \$ 932 Equity \$ 6,500 \$ 7,899
EAT \$ 1,399 Total L&E \$12,540 \$18,330
3. Lap Dogs Inc. is planning for next year and has the following summarized results so far
(\$000):
Income Statement
EBIT 236
Interest ?
EBT ?
Income Tax ?
EAT ?
Balance Sheet
This Year Next Year
Assets 582 745
Current Liabilities 63 80
Debt 275 ?
Equity 244 ?
Total Liab & Equity 582 745
The firm pays interest of 12% on all borrowing and is subject to an overall tax rate of 38%. It
paid interest of \$20,000 this year and plans a \$75,000 dividend next year. Complete Lap Dog’s
forecast of next year’s financial statements. Round all calculations to the nearest \$1,000.
Solution:
Using this year’s interest as a first guess at next year’s and completing the financial statements
yields the following:
Income Statement
EBIT 236
Interest 20
EBT 216
Income Tax 82
EAT 134
Balance Sheet
This Year Next Year
Assets 582 745
Current Liabilities 63 80
Debt 275 362
Equity 244 303
Total Liab & Equity 582 745
Check to see if the calculated average debt implies the interest guess
[(275 + 362) / 2] × .12 = 38
Since \$38,000 is not close to the \$20,000 guess, substitute \$38,000 and iterate again as follows:
Income Statement
EBIT 236
Interest 38
EBT 198
Income Tax 75
EAT 123
Balance Sheet
This Year Next Year
Assets 582 745
Current Liabilities 63 80
Debt 275 373
Equity 244 292
Total Liab & Equity 582 745
Check the new debt figures against the second guess at interest:
[(275 + 373) / 2] × .12 = 39
The result is within \$1,000 of the \$38,000 second guess which is satisfactory for planning
purposes.
4. The Libris Publishing Company had revenues of \$200 million this year and expects a 50%
growth to \$300 million next year. Costs and expenses other than interest are forecast at \$250
million. The firm currently has assets of \$280 million and current liabilities of \$40 million. Its
debt to equity ratio is 3:1. (I.e., capital is 75% debt and 25% equity.) It pays 12% interest on all
of its debt, and is subject to federal and state income taxes at a total effective rate of 39%.
Libris expects assets and current liabilities to grow at 40%, 10% less than the revenue growth
rate. The company plans to pay dividends of \$10 million next year.
a. What is the planned debt to equity ratio at the end of next year?
b. Do these results indicate a problem?
SOLUTION:
a. This is a slightly disguised version of the debt interest problem.
Next year’s EBIT is \$300  \$250 = \$50.
Beginning capital (debt+equity) is \$280  \$40 = \$240, which split 3:1 gives debt of \$180
and equity of \$60.
Next year’s total assets are \$280  1.4 = \$392, while current liabilities are \$40  1.4 = \$
56. Capital is \$392  \$56 = \$336. This sets up the debt-interest iteration problem. The result after
two iterations is shown below. Notice that Ending Equity = Beginning Equity + Net Income –
Dividends.
Income Statement Balance Sheet
Beginning Ending
Revenue \$300 Assets \$280 \$392
Cost/Exp 250
EBIT \$ 50 Liabilities
Interest 27 Current \$ 40 \$ 56
EBT \$ 23 Debt 180 272
Tax 9 Equity 60 64
EAT \$ 14 \$280 \$392
The ending debt equity mix is
Debt \$272 81%
Equity 64 19%
Capital \$336 100%
And Debt : Equity is 4.25 : 1
b. Libris may have a problem with this plan. The company’s debt level is dangerously high now,
and is forecast to go higher in the next year. The firm is borrowing to fund asset growth while
paying most of current earnings out in dividends. Lenders are quite likely to resist advancing
more funds under those conditions.
Plans with Simple Assumptions – Example 4.3 (page 140)
5. The management of Coker Corp is doing a quick forecast of 20X9 using the modified
percentage of sales method in preparation for a more detailed planning exercise later in the
month. The estimate is to assume a 10% growth in sales. All other line items are to be assumed
to grow at the same rate except for fixed assets which is projected to increase by \$88,000 due to
an expansion program already underway. Approximate financial statements for the current year,
20X8, and a planning worksheet are shown below. The firm pays 9% interest on all of its debt.
Assume the tax rate is a flat 25%. There are no plans for dividends or the sale of additional stock
next year. Make a forecast of Coker's complete income statement and balance sheet. Work to the
nearest thousand dollars. (Hints: The easiest way to grow a number by 10% is to multiply it by
1.1 rather than taking 10% and adding. Do not grow subtotals. For example grow Revenue and
COGS by 10% rounding each to the nearest thousand and subtract for Gross Margin. Don’t
grow interest, debt or equity, use the debt/interest iterative technique.)
COKER CORP
CURRENT AND PROJECTED INCOME STATEMENTS
(\$000)
20X8 20X9
Revenue \$642
COGS 289
Gross Margin \$353
Expenses \$240
EBIT \$113
Interest (9%) 33
EBT \$ 80
Inc Tax (25%) \$ 25
EAT \$ 55
COKER CORP
CURRENT AND PROJECTED BALANCE SHEETS
(\$000)
ASSETS LIABILITIES& EQUITY
20X8 20X9 20X8 20X9
C/A \$198 C/L \$ 87
F/A 552 Debt 325
Total \$750 Equity 338
Total \$750
SOLUTION: Applying management's assumptions and iterating for interest and debt yields the
following:
COKER CORP
CURRENT AND PROJECTED INCOME STATEMENTS
(\$000)
20X8 20X9
Revenue \$642 \$706
COGS 289 318
Gross Margin \$353 \$388
Expenses \$240 \$264
EBIT \$113 \$124
Interest (9%) 33 30
EBT \$ 80 \$ 94
Inc Tax (25%) \$ 25 24
EAT \$ 55 \$ 70
COKER CORP
CURRENT AND PROJECTED BALANCE SHEETS
(\$000)
ASSETS LIABILITIES& EQUITY
20X8 20X9 20X8 20X9
C/A \$198 \$218 C/L \$ 87 \$ 96
F/A 552 640 Debt 325 354
Total \$750 \$858 Equity 338 408
Total \$750 \$858
6. Larime Corp is forecasting 20X2 near the end of 20X1. The estimated year end financial
statements and a worksheet for the forecasts are shown below.
LARIME CORP
PROJECTED INCOME STATEMENT
(\$000)
20X1 20X2
\$%\$%
Revenue \$245,622 100.0 100.0
COGS \$142,461 58.0
Gross Margin \$103,161 42.0
Expenses \$ 49,124 20.0
EBIT \$ 54,037 22.0
Interest (12%) \$ 9,642 3.9
EBT \$ 44,395 18.1
Inc Tax (43%) \$ 19,090 7.8
EAT \$ 25,305 10.3
LARIME CORP
PROJECTED BALANCE SHEET
(\$000)
ASSETS LIABILITIES& EQUITY
20X1 20X2 20X1 20X2
C/A \$178,106 C/L \$ 85,700
F/A \$142,128 Debt \$ 78,178
Total \$320,234 Equity \$156,356
Total \$320,234
Management expects the following next year:

An 8% increase in revenue.

Price cutting will cause the cost ratio (COGS/Sales) to deteriorate (increase) by 1% of
sales from its current level.

Expenses will increase at a rate that is three quarters of that of sales.

C/A and C/L will increase proportionately with sales.



Net fixed assets will increase by \$5 million.
All interest will be paid at 12%.
Federal and state income taxes will be paid at a combined rate of 43%.
Make a forecast of Larime's complete income statement and balance sheet. Work to the nearest
thousand dollars.
SOLUTION: Applying management's assumptions and iterating for interest and debt yields the
following:
LARIME CORP
PROJECTED INCOME STATEMENT
(\$000)
20X1 20X2
\$%\$%
Revenue \$245,622 100.0 \$265,272 100.0
COGS \$142,461 58.0 \$156,510 59.0
Gross Margin \$103,161 42.0 \$108,762 41.0
Expenses \$ 49,124 20.0 \$ 52,071 19.6
EBIT \$ 54,037 22.0 \$ 56,691 21.4
Interest (12%) \$ 9,642 3.9 \$ 8,476 3.2
EBT \$ 44,395 18.1 \$ 48,215 18.2
Inc Tax (43%) \$ 19,090 7.8 \$ 20,732 7.8
EAT \$ 25,305 10.3 \$ 27,483 10.4
LARIME CORP
PROJECTED BALANCE SHEET
(\$000)
ASSETS LIABILITIES& EQUITY
20X1 20X2 20X1 20X2
C/A \$178,106 \$192,354 C/L \$ 85,700 \$ 92,556
F/A \$142,128 \$147,128 Debt \$ 78,178 \$ 63,087
Total \$320,234 \$339,482 Equity \$156,356 \$183,839
Total \$320,234 \$339,482
7. The Eagle Feather Fabric Company expects to complete the current year with the following
financial results (\$000).
INCOME STATEMENT BALANCE SHEET
Revenue \$36,100 Assets
COGS 14,440 Cash \$ 1,000
A/R 5,000
GM \$21,660 Inventory 2,888
Expenses 12,635 Curr Assets \$ 8,888
EBIT \$ 9,025 Net F/A \$ 7,250
Int (11%) \$ 625 Total Assets \$16,138
EBT \$ 8,400
Tax (42%) \$ 3,528 Liabilities & Equity
EAT \$ 4,872 Accts Payable \$ 1,550
Accruals 530
C/L \$ 2,080
Debt \$ 5,598
Equity \$ 8,460
Total L&E \$16,138
Forecast next year using a modified percentage of sales method assuming no dividends are paid
and no new stock is sold along with the following. (Note that negative debt in a forecast means
the business will generate more cash than is currently owed.)
a. a 20% growth in sales and a 40% growth in net fixed assets.
b. A 15% growth in sales with a 10% growth in expenses and a 20% growth in net fixed assets.
(Negative debt means the business will generate more cash than is currently owed.)
SOLUTION:
INCOME STATEMENT
Current Year a b
Revenue \$36,100 \$43,320 \$41,515
COGS 14,440 17,328 16,606
GM \$21,660 \$25,992 \$24,909
Expenses 12,635 15,162 13,899
EBIT \$ 9,025 \$10,830 \$11,010
Interest (11%) \$ 625 521 414
EBT \$ 8,400 \$10,309 \$10,596
Tax (42%) \$ 3,528 4,330 4,450
EAT \$ 4,872 \$ 5,979 \$ 6,146
BALANCE SHEET
ASSETS
Cash \$ 1,000 \$ 1,200 \$ 1,150
A/R 5,000 \$ 6,000 \$ 5,750
Inventory 2,888 \$ 3,466 \$ 3,321
Current Assets \$ 8,888 \$10,666 \$10,221
Net F/A \$ 7,250 \$10,150 \$ 8,700
Total Assets \$16,138 \$20,816 \$18,921
LIABILITIES& EQUITY
Accts Payable \$ 1,550 \$ 1,860 \$ 1,783
Accruals \$ 530 \$ 636 \$ 609
C/L \$ 2,080 \$ 2,496 \$ 2,392
Debt \$ 5,598 \$ 3,881 \$ 1,923
Equity \$ 8,460 \$14,439 \$14,606
Total L&E \$16,138 \$20,816 \$18,921
External Funding Requirement (EFR) – Example 4.4 (page 145)
8. Fleming, Inc. had a dividend payout ratio of 25% this year that resulted in a payout of \$80,000
in dividends. Return on sales (ROS) was 8% this year and is expected to increase to 9% next
year. If Fleming expects to have \$305,100 available from next year’s retained earnings, what
percent increase are they forecasting in revenues?
SOLUTION:
This year’s EAT = \$80,000/.25 = \$320,000
This year’s revenues = \$320,000/.08 = \$4,000,000
Next year’s EAT = \$305,100/.75 = \$406,800
Next year’s revenue = \$406,800/.09 = \$4,520,000
% Increase in revenue = (4.52 – 4.0)/4.0 = 13%
9. The Dalmation Corporation expects the following summarized financial results this year
(\$000)
INCOME STATEMENT BALANCE SHEET
Revenue \$10,500 Assets
Cost/Exp. 9,100 Curr Assets \$ 5,500
Tax \$ 560 Net F/A \$ 6,900
EAT \$ 840 Total Assets \$12,400
Dividends \$ 420
Liabilities& Equity
Current \$ 320
Debt \$ 5,080
Equity \$ 7,000
Total L&E \$12,400
Use the EFR relation to estimate Dalmation's external funding requirements under the following
conditions.
a. Sales growth of 15%.
b. Sales growth of 20% and a reduction in the payout ratio to 25%.
c. Sales growth of 25%, elimination of dividends, and a 4% improvement in ROS to 12%.
SOLUTION:
a. EBT = \$10,500  \$9,100 = \$1,400
Tax rate = \$560/\$1,400 = 40%
ROS = \$840/\$10,500 = 8%
EFR = g(ASSETS)  g(C/L)  (1-d)ROS(1+g)SALES
a. EFR = .15(\$12,400)  .15(\$320)  (1.5)(.08)(1.15)(\$10,500)
= \$1,860  \$48  \$483
= \$1,329
b. EFR = .20(\$12,400)  .20(\$320)  (1.25)(.08)(1.20)(\$10,500)
= \$2,480  \$64  \$756
= \$1,660
c. EFR = .25(\$12,400)  .25(\$320)  (1)(.12)(1.25)(\$10,500)
= \$3,100  \$80  \$1,575
= \$1,445
10. Lytle Trucking projects a \$3.2 million EBIT next year. The firm’s marginal tax rate is 40%,
and it currently has \$8 million in long-term debt with an average coupon rate of 8%.
Management is projecting a requirement for additional assets costing \$1.5 million and no change
in current liabilities. They plan to maintain a 30% dividend payout ratio. Any additional
borrowing required to fund next year’s asset growth will carry a 7% coupon rate. Lytle does not
plan to issue additional stock next year. Use the EFR concept rather than the EFR equation to
develop an algebraic formula of your own to compute the additional debt needed to support a
asset growth of \$1.5 million. (Hint: Start with the idea that additional debt = new assets –
internally generated funds.Then write an algebraic expression for internally generated funds
based on the income statement from EBIT to EAT and the dividend payout ratio.)
SOLUTION:
NA = new assets RE = retained earnings = internally generated funds
T = tax rate d = dividend payout ratio
I = interest = .08D + .07AD
In general
EAT = EBT(1-T) EBT = EBIT – I RE = EAT(1-d)
Substituting gives
EAT = [EBIT – (.08D + .07AD)](1-T)
Now write the expression for additional debt
= NA – EAT(1-d)
Substitute for EAT
Substitute values (\$M) from the problem
From which
Sustainable Growth Rate – Example 4.5 (page 147)
11. The Bubar Building Co. has the following current financial results (\$000).
Revenue \$45,000 Assets \$37,500
EAT \$ 3,600 Equity \$28,580
Dividends \$ 1,800
On the average, other building companies pay about one quarter of their earnings in dividends,
earn about six cents on the sales dollar, carry assets worth about six months of sales, and finance
one third of their assets with debt.
Use the sustainable growth rate concept to analyze Bubar's inherent ability to grow without
selling new equity versus that of an average building company. Identify weak areas and suggest
further analyses.
SOLUTION:
gs = (1-d)  ROS  T/A  Equity
______ Turnover Multiplier
Bubar 6.24% = .5 8% 1.2 1.3
Industry 13.5% = .75 6% 2.0 1.5
Bubar's problems are its payout ratio and its asset utilization. The firm can't grow rapidly without
some equity capital, and it's paying most of its earnings out in dividends. It also seems to be
using its assets inefficiently. Management should check out old A/R, dead inventory, and fixed
assets that aren't being used.
12. Broxholme Industries has sales of \$40 million, equity totaling \$27.5 million and an ROS of
12%. The sustainable growth rate has been calculated at 10.9%. What dividend payout ratio was
assumed in this calculation?
SOLUTION: (\$M)
ROS = EAT / Sales
From which
EAT = Sales (ROS)
= \$40(.12)
= \$4.8
Write the sustainable growth formula
gS = EAT(1-d) / equity
Substituting for EAT and equity yields
.109 = \$4.8(1–d)]/\$27.5
from which
d = .375 = 37.5%
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