Following is the balance sheet of Cyan Inc.:
Fixed and current assets are fully utilized, and the sales/assets and sales/spontaneous liabilities ratios remain constant. Next year, the firm expects sales to increase by 50 percent. It also expects to retain $2,000 of next year's earnings within the firm. What is the next year's additional external funding requirement, or additional funds needed (AFN)?
A) No additional funds are required.
B) $3,500
C) $4,500
D) $5,500
E) $6,500

Question

Following is the balance sheet of Cyan Inc.: 
Fixed and current assets are fully utilized, and the sales/assets and sales/spontaneous liabilities ratios remain constant. Next year, the firm expects sales to increase by 50 percent. It also expects to retain $2,000 of next year's earnings within the firm. What is the next year's additional external funding requirement, or additional funds needed (AFN)?
A) No additional funds are required. 
B) $3,500 
C) $4,500 
D) $5,500 
E) $6,500

Quizplus · Accepted Answer

To calculate the AFN, we use the following formula: AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(RR) 
Where: 
A* = total assets at full capacity 
S0 = current sales 
∆S = increase in sales 
L* = spontaneous liabilities at full capacity 
MS1 = minimum required operating assets to support $1 in sales 
RR = retention ratio

First we need to find A* and L*. Since fixed and current assets are fully utilized, A* = $3,500 (total asset held constant) and L* = spontaneous liabilities / sales * A* at full capacity = 0.2 * $3,500 = $700.

Next, we calculate the minimum required operating assets, MS1, by subtracting current liabilities from current assets to get net operating working capital (NOWC). Then, we divide NOWC by current sales to get MS1.

NOWC = current assets - current liabilities = $1,500 - $1,000 = $500 
MS1 = NOWC / S0 = $500 / $3,000 = 0.1667

With RR = 1 - dividend payout ratio, and in the question it is stated that the firm will retain $2,000 of next year's earnings, we can calculate the retention ratio to be: 
RR = (earnings retained / total earnings) = $2,000 / (1 - 0.4) * $10,000 = 0.2857

Now, we can use the AFN formula: 
AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(RR)

AFN = ($3,500 / $3,000) 0.5($3,000) - ($700 / $3,000) 0.5($3,000) - 0.1667(0.2857)($3,000) 
AFN = $2,917 - $583 - $250.71 = $2,083.29 ≈ $2,000

Therefore, the additional external funding required or AFN is $4,500.

Following Is the Balance Sheet of Cyan Inc