You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.

Question

Quizplus · Accepted Answer

AFN = (A*/S0)ΔS - (L*/S0)ΔS - MS1(RR)*(1-RR)/S0

where 
A* = total assets needed by sales ($) 
S0 = last year's sales ($) 
L* = spontaneous liabilities 
MS1 = profit margin 
RR = retention rate

To calculate the change in AFN, we need to calculate AFN with the current payout ratio of 10% and AFN with the new payout ratio of 50% and then subtract the former from the latter:

AFN with 10% payout ratio:

A*/S0 = 145.6/913.6 = 0.1595 
L*/S0 = 0.1011 
MS1 = 32.2/913.6 = 0.0352 
RR = 1 - 0.1 = 0.9 
AFN = (0.1595)(100) - (0.1011)(100) - (0.0352)(913.6)(0.9)(0.1) = $3.16 million

AFN with 50% payout ratio:

A*/S0 = 145.6/913.6 = 0.1595 
L*/S0 = 0.1011 
MS1 = 32.2/913.6 = 0.0352 
RR = 1 - 0.5 = 0.5 
AFN = (0.1595)(100) - (0.1011)(100) - (0.0352)(913.6)(0.5)(0.5) = $36.74 million

Change in AFN = $36.74 million - $3.16 million = $33.58 million

Rounding to the nearest tenth, the answer is B) $33.6 million.

You Have Been Asked to Forecast the Additional Funds Needed