A firm has the following statement of financial position: Fixed assets are being used at 80 percent of capacity; sales for the year just ended were R200; sales will increase R10 per year for the next 4 years; the profit margin is 5 percent; and the dividend payout ratio is 60 percent.Assume that fixed assets cannot be sold.What are the total external financing requirements for the entire 4 years, i.e., the total AFN for the 4-year period?

Question

A firm has the following statement of financial position:  Fixed assets are being used at 80 percent of capacity; sales for the year just ended were R200; sales will increase R10 per year for the next 4 years; the profit margin is 5 percent; and the dividend payout ratio is 60 percent.Assume that fixed assets cannot be sold.What are the total external financing requirements for the entire 4 years, i.e., the total AFN for the 4-year period?

Quizplus · Accepted Answer

We need to calculate the Additional Financing Needed (AFN) for each of the 4 years and add them up to get the total AFN for the 4-year period.

Year 1: 
Sales = R200 
Projected Sales Next Year = R210 (increase of R10) 
Assets needed to support sales increase = (R210 / 0.8) - R250 = R62.50 
AFN = Assets needed - Internal financing = R62.50 - (0.05 x R200) = R52.50

Year 2: 
Sales = R210 
Projected Sales Next Year = R220 (increase of R10) 
Assets needed to support sales increase = (R220 / 0.8) - R250 = R67.50 
AFN = Assets needed - Internal financing = R67.50 - (0.05 x R210) = R56.25

Year 3: 
Sales = R220 
Projected Sales Next Year = R230 (increase of R10) 
Assets needed to support sales increase = (R230 / 0.8) - R250 = R72.50 
AFN = Assets needed - Internal financing = R72.50 - (0.05 x R220) = R60.25

Year 4: 
Sales = R230 
Projected Sales Next Year = R240 (increase of R10) 
Assets needed to support sales increase = (R240 / 0.8) - R250 = R77.50 
AFN = Assets needed - Internal financing = R77.50 - (0.05 x R230) = R64.25

Total AFN for 4-year period = R52.50 + R56.25 + R60.25 + R64.25 = R233.25 
However, the firm has a dividend payout ratio of 60%, meaning that 60% of earnings will be paid out as dividends. 
Annual Net Income = Sales x Profit Margin = R200 x 0.05 = R10 
Dividends Paid = 60% x R10 = R6 
Internal Financing = R10 - R6 = R4 
Therefore, the Total AFN for the 4-year period is: 
R233.25 - (R4 x 4) = R217.25

Since the result is negative, it means that the firm has a surplus of R217.25 over the next 4 years and does not require any external financing. Thus, the answer is D.

A Firm Has the Following Statement of Financial Position