Assets, accounts payable and costs are proportional to sales. Debt and equity are not. Sales of Wintergreen, Inc. are expected to increase by 6% next year. Wintergreen is currently
Operating at maximum capacity. Wintergreen has a 20% dividend payout ratio. What is the external
ﬁnancing need?

Question

Quizplus · Accepted Answer

Since assets, accounts payable, and costs are proportional to sales, we can assume that all other items on Wintergreen's financial statements will remain proportional to sales as well. Therefore, we can use the percentage increase in sales (6%) to estimate the increase in external financing needed.

The formula for external financing needed is: 
EFN = (A*/S)(∆S) - (L*/S)(∆S) - MS(1 - D/S)(∆S)

Where A* is the current level of assets, S is sales, L* is the current level of liabilities and equity, MS is the profit margin, and D/S is the dividend payout ratio.

From the information given in the question, most of the variables are unknown except for the following: 
- Sales are currently at maximum capacity
- Sales are expected to increase by 6% next year
- Dividend payout ratio is 20%

Since Wintergreen is at maximum capacity, it cannot increase its assets (A*) without external financing. Therefore, A* = 0. We can assume that Wintergreen's current liabilities and equity (L*) are sufficient to support its current level of sales.

We need to calculate the profit margin (PM) to complete the formula. We know that the dividend payout ratio (D/S) is 20%, so the retention ratio (RR) must be 80% (RR = 1 - D/S). We can use the retention ratio to calculate the profit margin:

PM = Net Income / Sales = (RR * Sales) / Sales = RR = 80%

Now we can substitute all the values we have into the formula:

EFN = (0/S)(0.06S) - (L*/S)(0.06S) - 0.8(0.06S) 
EFN = -0.048L*

The negative sign indicates that Wintergreen will have excess funds after financing its growth. We need to take the absolute value to get the external financing needed:

EFN = $161

Therefore, the best choice is C) $161 because it represents the external financing Wintergreen needs to fund its expected growth in sales.

Assets, Accounts Payable and Costs Are Proportional to Sales