Brown & Sons recently reported sales of $100 million, and net income equal to $5 million. The company has $70 million in total assets. Over the next year, the company is forecasting a 20 percent increase in sales. Since the company is at full capacity, its assets must increase in proportion to sales. The company also estimates that if sales increase 20 percent, spontaneous liabilities will increase by $2 million. If the company's sales increase, its profit margin will remain at its current level. The company's dividend payout ratio is 40 percent. Based on the AFN formula, how much additional capital must the company raise in order to support the 20 percent increase in sales?

Question

Quizplus · Accepted Answer

Using the AFN formula:

AFN = (A*/S0)ΔS - (L*/S0)ΔS - MS1(RR)

A*/S0 = 70/100 = 0.7
ΔS = 20% of $100 million = $20 million
L*/S0 = spontaneous liabilities/initial sales = $2 million/$100 million = 0.02
MS1 = net income/sales = $5 million/$100 million = 0.05
RR = retention ratio = 1 - dividend payout ratio = 1 - 0.4 = 0.6

AFN = (0.7)$20 million - (0.02)$20 million - (0.05)$20 million(0.6)
AFN = $14 million - $400,000 - $600,000
AFN = $13 million

Therefore, the company must raise an additional $8.4 million ($13 million - $4.6 million in retained earnings) in order to support the 20 percent increase in sales. The correct answer is C.

Brown & Sons Recently Reported Sales of $100 Million, and Net