The Paper Mill is operating at full capacity. Assets, costs, and current liabilities vary directly with sales. The dividend payout ratio is constant. The firm has sales of $42,700, net income of $5,500, total assets of $48,900, current liabilities of $3,650, long-term debt of $18,100, owners' equity of $27,150, and dividends of $1,925. What is the external financing need if sales increase by 14 percent?

Question

Quizplus · Accepted Answer

First, we need to find the firm's current total liabilities and total equity:

Total liabilities = Current liabilities + Long-term debt = $3,650 + $18,100 = $21,750

Total equity = Owners' equity = $27,150

Next, we use the equation for the external financing needed:

EFN = (A*/S0)ΔS - (L*/S0)ΔS - MS1(RR)

Where:

A* = Total assets
S0 = Initial sales
L* = Total liabilities and equity
ΔS = Increase in sales
MS1 = Net income margin = Net income / Sales
RR = Dividend payout ratio = Dividends / Net income

Plugging in the numbers:

EFN = ($48,900/$42,700) x 0.14 - ($21,750/$42,700) x 0.14 - $5,500 x (1 - $1,925/$5,500)
EFN = $2,260

Since the answer is positive, the company requires external financing to support the increase in sales. Option E is the best choice.

The Paper Mill Is Operating at Full Capacity