Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.
A) $31.9
B) $33.6
C) $35.3
D) $37.0
E) $38.9

Question

Quizplus · Accepted Answer

AFN equation is:

AFN = (A*/S0) ΔS - (L*/S0) ΔS - MS1(1 - S1)/S0

where,

A* = Total assets for the coming year
S0 = Spontaneous liabilities for the current year
L* = Total liabilities for the coming year
ΔS = Increase in sales
MS1 = Additional funds required (AFN) ratio
S1 = Projected sales to assets ratio

Given data:

Sales for the current year = S0 = $450
Projected sales to assets ratio = S1 = 1.2
Costs, expenses, and dividends are projected to be constant at 75% of sales
Current total assets = $900
Current liabilities = $180
Current spontaneous liabilities = $135
Target debt ratio = 40%
Tax rate = 35%

Calculations:

Total liabilities = Debt/Equity * Total equity
Total equity = Total assets - Total liabilities
Total liabilities = 0.4 * (Total assets - Total liabilities)
0.6 * Total liabilities = 0.4 * Total assets
Total liabilities = (0.4/0.6) * Total assets = 0.67 * Total assets
L* = Total liabilities for the coming year = 0.67 * A* = 0.67 * $990 = $663.3 million
A* = Total assets for the coming year = Sales / Assets ratio = S1* S0 = 1.2 * $450 = $540 million
Projected costs, expenses, and dividends = 0.75 sales = 0.75 * $450 = $337.5 million
Net income = Sales - Costs, expenses, and dividends = $450 - $337.5 = $112.5 million
Dividends payout ratio = 10% or 50%
Dividends = Net income * Dividends payout ratio
If the dividend payout ratio is 10%, then dividends = $11.25 million
If the dividend payout ratio is 50%, then dividends = $56.25 million
Addition to retained earnings = Net income - Dividends
If the dividend payout ratio is 10%, then Addition to retained earnings = $112.5 - $11.25 = $101.25 million
If the dividend payout ratio is 50%, then Addition to retained earnings = $112.5 - $56.25 = $56.25 million
Assets required to support projected sales = A*/S0 * ΔS = $540/$450 * 1 = $1.2 million
Increase in spontaneous liabilities = (ΔS * spontaneous liabilities/sales) = 1 * ($135/$450) = $0.3 million
Additional funds needed (AFN) = $38.25 million (when dividends payout ratio is 10%)
Additional funds needed (AFN) = $71.1 million (when dividends payout ratio is 50%)
Change in AFN = $71.1 million - $38.25 million = $32.85 million = $33.6 million (approx)

Therefore, the answer is B) $33.6

Howton & Howton Worldwide (HHW) Is Planning Its Operations for the Coming