Suppose that BBM Industries, Inc. currently has the balance sheet shown as follows, and that sales for the year just ended were $2 million. The firm also has a profit margin of 5 percent, a retention ratio of 50 percent, and expects sales of $2.5 million next year. If all assets and current liabilities are expected to increase with sales, what amount of additional funds will the company need from external sources to fund the expected growth?
A)$0
B)$62,500
C)$437,500
D)$500,000

Question

Suppose that BBM Industries, Inc. currently has the balance sheet shown as follows, and that sales for the year just ended were $2 million. The firm also has a profit margin of 5 percent, a retention ratio of 50 percent, and expects sales of $2.5 million next year. If all assets and current liabilities are expected to increase with sales, what amount of additional funds will the company need from external sources to fund the expected growth? 
A)$0 
B)$62,500 
C)$437,500 
D)$500,000

Quizplus · Accepted Answer

First, we need to calculate BBM Industries' expected net income for next year: 
Expected sales = $2.5 million 
Profit margin = 5% 
Expected net income = $2.5 million x 5% = $125,000

Since the retention ratio is 50%, we can assume that half of the net income will be retained and added to equity, and the other half will be paid out as dividends. Therefore, expected addition to equity = $125,000/2 = $62,500

Next, we need to calculate the total assets and current liabilities for next year, assuming they will increase with sales: 
Current assets = $700,000 x ($2.5 million/$2 million) = $875,000 
Fixed assets = $1,300,000 x ($2.5 million/$2 million) = $1,625,000 
Total assets = $875,000 + $1,625,000 = $2,500,000

Current liabilities = $300,000 x ($2.5 million/$2 million) = $375,000

Now we can use the external financing needed (EFN) equation to calculate how much additional funds BBM Industries will need from external sources:

EFN = (A*/S0) ΔS - (L*/S0) ΔS - MS1

Where: 
A* = Total assets for next year 
S0 = Sales for this year 
ΔS = Increase in sales 
L* = Current liabilities for next year 
MS1 = Retention ratio x Expected net income for next year

Plugging the values into the formula:

EFN = ($2,500,000/$2,000,000) x ($2.5 million - $2 million) - ($375,000/$2,000,000) x ($2.5 million - $2 million) - $62,500 
EFN = $500,000 - $93,750 - $62,500 
EFN = $343,750

Therefore, BBM Industries will need $343,750 in additional funds from external sources to fund the expected growth. The closest answer choice is C) $437,500.

Suppose That BBM Industries, Inc