Chapter 12( 14th ed.

)
Corporate Valuation and Financial Planning
ANSWERS TO END-OF-CHAPTER QUESTIONS

12-1 a. The operating plan provides detailed implementation guidance designed to

accomplish corporate objectives. It details who is responsible for what particular
function, and when specific tasks are to be accomplished. The financial plan details
the financial aspects of the corporation’s operating plan.

b. Spontaneous liabilities are the first source of expansion capital as these accounts
increase automatically through normal business operations. Examples of spontaneous
liabilities include accounts payable, accrued wages, and accrued taxes. No interest is
normally paid on these spontaneous liabilities; however, their amounts are limited due
to credit terms, contracts with workers, and tax laws. Therefore, spontaneous
liabilities are used to the extent possible, but there is little flexibility in their usage.
Note that notes payable, although a current liability account, is not a spontaneous
liability since an increase in notes payable requires a specific action between the firm
and a creditor. A firm’s profit margin is calculated as net income divided by sales.
The higher a firm’s profit margin, the larger the firm’s net income available to
support increases in its assets. Consequently, the firm’s need for external financing
will be lower. A firm’s payout ratio is calculated as dividends per share divided by
earnings per share. The less of its income a company distributes as dividends, the
larger its addition to retained earnings. Therefore, the firm’s need for external
financing will be lower.

Answers and Solutions: 12 - 1

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
 c. Additional funds needed (AFN) are those funds required from external sources to
increase the firm’s assets to support a sales increase. A sales increase will normally
require an increase in assets. However, some of this increase is usually offset by a
spontaneous increase in liabilities as well as by earnings retained in the firm. Those
funds that are required but not generated internally must be obtained from external
sources. Although most firms’ forecasts of capital requirements are made by
developing forecasted financial statements, the AFN formula is sometimes used as an
approximation of financial requirements. It is written as follows:

Additional Required Increase in Increase in

funds = asset – spontaneou s – retained
needed increase liab. earnings
AFN = (A0*/S0)S – (L0*/S0)S – MS1(1 – Payout rate)

Capital intensity is the dollar amount of assets required to produce a dollar of sales.
The capital intensity ratio is the reciprocal of the total assets turnover ratio. It is
calculated as Assets/Sales. The sustainable growth rate is the maximum growth rate
the firm could achieve without having to raise any external capital. A firm’s self-
supporting growth rate can be calculated as follows:

M(1  POR)(S0 )
Self-supporting g =
A 0 *  L 0 *  M(1  POR)(S0 )

d. The forecasted financial statement approach using percent of sales develops a

complete set of financial statements that can be used to calculate projected EPS, free
cash flow, various other financial ratios, and a projected stock price. This approach
first forecasts sales, the required assets, the funds that will be spontaneously
generated, and then net income, dividends, and retained earnings.

e. A firm has excess capacity when its sales can grow before it must add fixed assets
such as plant and equipment. “Lumpy” assets are those assets that cannot be acquired
smoothly, but require large, discrete additions. For example, an electric utility that is
operating at full capacity cannot add a small amount of generating capacity, at least
not economically. When economies of scale occur, the ratios are likely to change
over time as the size of the firm increases. For example, retailers often need to
maintain base stocks of different inventory items, even if current sales are quite low.
As sales expand, inventories may then grow less rapidly than sales, so the ratio of
inventory to sales declines.

Answers and Solutions: 12 - 2

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
 f. Full capacity sales are calculated as actual sales divided by the percentage of capacity
at which fixed assets were operated. The target fixed assets to sales ratio is calculated
as actual fixed assets divided by full capacity sales. The required level of sales is
calculated as the target fixed assets to sales ratio multiplied by the projected sales
level.

12-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously. Retained
earnings may or may not increase, depending on profitability and dividend payout policy.

12-3 The equation gives good forecasts of financial requirements if the ratios A0*/S and L0*/S,
the profit margin, and payout ratio are stable. This equation assumes that ratios are
constant. This would not occur if there were economies of scale, excess capacity, or
when lumpy assets are required. Otherwise, the forecasted financial statement method
should be used.

12-4 The five key factors that impact a firm’s external financing requirements are: Sales
growth, capital intensity, spontaneous liabilities-to-sales ratio, profit margin, and payout
ratio.

12-5 The self-supporting growth rate is the maximum rate a firm can achieve without having
to raise external capital. The self-supporting growth rate is calculated using the AFN
equation, setting AFN equal to zero, replacing the term ΔS with the term g × S 0, and
replacing the term S1 with S0 × (1 + g). Once the AFN equation is rewritten with these
modifications, you can now solve for g. This “g” obtained is the firm’s self-supporting
growth rate.

12-6 a. +.

b. +. It reduces spontaneous funds; however, it may eventually increase retained

earnings.

c. +.

d. +.

e. –.

f. –.

Answers and Solutions: 12 - 3

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

12-1 AFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate)

 $5,000,000   $900,000 
=  $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)
 $8,000,000   $8,000,000 
= (0.625)($1,200,000) – (0.1125)($1,200,000) – ($552,000)(0.6)
= $750,000 – $135,000 – $331,200
= $283,800.

 $7,000,000   $900,000 
12-2 AFN =   $1,200,000 –   $1,200,000 – 0.06($9,200,000)(1 – 0.4)
 $8,000,000   $8,000,000 
= (0.875)($1,200,000) – $135,000 – $331,200
= $1,050,000 – $466,200
= $583,800.

The capital intensity ratio is measured as A0*/S0. This firm’s capital intensity ratio is
higher than that of the firm in Problem 9-1; therefore, this firm is more capital
intensive—it would require a large increase in total assets to support the increase in
sales.

12-3 AFN = (0.625)($1,200,000) – (0.1125)($1,200,000) – 0.06($9,200,000)(1 – 0)

= $750,000 – $135,000 – $552,000
= $63,000.

Under this scenario the company would have a higher level of retained earnings
which would reduce the amount of additional funds needed.

Answers and Solutions: 12 - 4

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website, in whole or in part.
12-4 S0 = $5,000,000; A0* = $2,500,000; CL = $700,000; NP = $300,000; AP = $500,000;
Accruals = $200,000; M = 7%; payout ratio = 80%; A0*/S0 = 0.50; L0* = (AP +
Accruals)/S0 = ($500,000 + $200,000)/$5,000,000 = 0.14.

AFN = (A0*/S0)∆S – (L0*/S0)∆S – (M)(S1)(1 – payout rate)

= (0.50)∆S – (0.14) ∆S – (0.07)(S1)(1 – 0.8)
= (0.50)∆S – (0.14)∆S – (0.014)S1
= (0.36)∆S – (0.014)S1
= 0.36(S1 – S0) – (0.014)S1
= 0.36(S1 – $5,000,000) – (0.014)S1
= 0.36S1 – $1,800,000 – 0.014S1
$1,800,000 = 0.346S1
$5,202,312 = S1.

Sales can increase by $5,202,312 – $5,000,000 = $202,312 without additional funds

being needed.

12-5 a. Total liab. = Accounts + Long -term + Common + Retained

and equity payable debt stock earnings
$2,170,000 = $560,000 + Long-term debt + $625,000 + $395,000

Long-term debt = $590,000.

Total liab. = Accounts payable + Long-term debt

= $560,000 + $590,000 = $1,150,000.

b. Assets/Sales (A0*/S0) = $2,170,000/$3,500,000 = 62%.

L0*/Sales = $560,000/$3,500,000 = 16%.
2014 Sales = (1.35)($3,500,000) = $4,725,000.

AFN = (A0*/S0)(∆S) – (L0*/S0)(∆S) – (M)(S1)(1 – payout) – New common stock

= (0.62)($1,225,000) - (0.16)($1,225,000) - (0.05)($4,725,000)(0.55) - $195,000
= $759,500 - $196,000 - $129,937 - $195,000 = $238,563.

Alternatively, using the forecasted financial statement method:

Answers and Solutions: 12 - 5

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website, in whole or in part.
 Forecast
Basis % Additions (New
2013 2014 Sales Financing, R/E) 2014
Total assets $2,170,000 0.62 $2,929,500
Current liabilities $ 560,000 0.16 $ 756,000
Long-term debt 590,000 590,000
Total liabilities $ 1,150,000 $ 1,346,000
Common stock 625,000 195,000* 820,000
Retained earnings 395,000 129,937** 524,937
Total common equity $ 1,020,000 $ 1,344,937
Total liabilities
and equity $2,170,000 $2,690,937

AFN = Additional long-term debt = 2,929,500 – 2,690,937 = $ 238,563

*Given in problem that firm will sell new common stock = $195,000.
**PM = 5%; Payout = 45%; NI2014 = $3,500,000 x 1.35 x 0.05 = $236,250.
Addition to RE = NI x (1 - Payout) = $236,250 x 0.33 = $129,937.

Answers and Solutions: 12 - 6

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website, in whole or in part.
12-6 Cash $ 100.00  2.0 = $ 200.00
Accounts receivable 200.00  2.0 = 400.00
Inventories 200.00  2.0 = 400.00
Net fixed assets* 500.00  1.0 = 500.00
Total assets $1,000.00 $1,500.00

Accounts payable $ 50.00  2 = $ 100.00

Accruals 50.00  2 = 100.00
Notes payable 150.00 + 0 = 150.00
Long-term debt 400.00 + 0 = 400.00
Common stock 100.00 + 0 = 100.00
Retained earnings** 250.00 + 40 = 290.00
Total liabilities
and equity $1,000.00 $1,140.00
AFN = $ 360.00

*Capacity sales = Sales/0.5 = $1,000/0.5 = $2,000 with respect to existing fixed assets.

Target FA/S ratio = $500/$2,000 = 0.25.

Target FA = 0.25($2,000) = $500 = Required FA. Since the firm currently has $500 of
fixed assets, no new fixed assets will be required.

**Addition to RE = (M)(S1)(1 – Payout ratio) = 0.05($2,000)(0.4) = $40.

12-7 a. AFN = (A0*/S0)(S) – (L0*/S0)(S) – (M)(S1)(1 – payout)

$122.5 $17.5 $10.5
= ($70) – ($70) – ($420)(0.6) = $13.44 million.
$350 $350 $350

M(1  POR)(S0 )
b. Self-supporting g =
A 0 *  L 0 *  M(1  POR)(S0 )

0.03(1  0.40)( 350)

=
122.5  17.5  .03(1  .4)( 350)

= 6.38%

Answers and Solutions: 12 - 7

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website, in whole or in part.
 c. Upton Computers
Pro Forma Balance Sheet
December 31, 2014
(Millions of Dollars)
Forecast 2014 Pro
Basis % 2014 Pro Forma after
2013 2014 Sales Additions Forma Financing Financing
Cash $ 3.5 0.0100 $ 4.20 $ 4.20
Receivables 26.0 0.0743 31.20 31.20
Inventories 58.0 0.1657 69.60 69.60
Total current assets $ 87.5 $105.00 $105.00
Net fixed assets 35.0 0.100 42.00 42.00
Total assets $122.5 $147.00 $147.00

Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80

Notes payable 18.0 18.00 18.00
Line of credit 0.0 0.00 +13.44 +13.44
Accruals 8.5 0.0243 10.20 10.20
Total current liabilities $ 35.5 $ 39.00 $ 52.44
Mortgage loan 6.0 6.00 6.00
Common stock 15.0 15.00 15.00
Retained earnings 66.0 7.56* 73.56 73.56
Total liab. and equity $122.5 $133.56 $147.00

Deficit = $ 13.44
*M = $10.5/$350 = 3%.
Payout = $4.2/$10.5 = 40%.
NI = $350  1.2  0.03 = $12.6.
Addition to RE = NI – DIV = $12.6 – 0.4($12.6) = 0.6($12.6) = $7.56.

Answers and Solutions: 12 - 8

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website, in whole or in part.
12-8 Stevens Textiles
Pro Forma Income Statement
December 31, 2014
(Thousands of Dollars)

a.
2014
Forecast 2014
2013 Basis Pro Forma
Sales $36,000 1.15  Sales13 $41,400
Operating costs 32,440 0.9011  Sales14 37,306
EBIT $ 3,560 $ 4,094
Interest 460 0.10 × Debt13 560
EBT $ 3,100 $ 3,534
Taxes (40%) 1,240 1,414
Net income $ 1,860 $ 2,120

Dividends (45%) $ 837 $ 954

Addition to RE $ 1,023 $ 1,166

Answers and Solutions: 12 - 9

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website, in whole or in part.
 Stevens Textiles
Pro Forma Balance Sheet
December 31, 2014
(Thousands of Dollars)
Forecast 2014 Pro
Basis % 2014 Pro 2014 Forma after
2013 2014 Sales Additions Forma Financing Financing
Cash $ 1,080 0.0300 $ 1,242 $ 1,242
Accts receivable 6,480 0.1800 7,452 7,452
Inventories 9,000 0.2500 10,350 10,350
Total curr. assets $16,560 $19,044 $19,044
Fixed assets 12,600 0.3500 14,490 14,490
Total assets $29,160 $33,534 $33,534

Accounts payable $ 4,320 0.1200 $ 4,968 $ 4,968

Accruals 2,880 0.0800 3,312 3,312
Line of credit 0 0 +2,128 +2,128
Notes payable 2,100 2,100 +2,128
Total curr. liabilities $ 9,300 $10,380 $12,508
Long-term debt 3,500 3,500 3,500
Total debt $12,800 $13,880 $16,008
Common stock 3,500 3,500 3,500
Retained earnings 12,860 1,166* 14,026 14,026
Total liab. and equity $29,160 $31,406 $33,534
Deficit = $ 2,128

*From income statement.

b. Line of credit = $2,128 (thousands of $).

c. If debt is added throughout the year rather than only at the end of the year, interest
expense will be higher than in the projections of part a. This would cause net income to
be lower, the addition to retained earnings to be higher, and the AFN to be higher. Thus,
you would have to add more than $2,228 in new debt. This is called the financing
feedback effect.

Answers and Solutions: 12 - 10

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website, in whole or in part.
12-9 Garlington Technologies Inc.
Pro Forma Income Statement
December 31, 2014

Forecast Pro Forma

2013 Basis 2014
Sales $3,600,000 1.10  Sales13 $3,960,000
Operating costs 3,279,720 0.911  Sales14 3,607,692
EBIT $ 320,280 $ 352,308
Interest 18,280 0.13 × Debt13 20,280
EBT $ 302,000 $ 332,028
Taxes (40%) 120,800 132,811
Net income $ 181,200 $ 199,217

Dividends: $ 108,000 Set by management $ 112,000

Addition to RE: $ 73,200 $ 87,217

Garlington Technologies Inc.

Pro Forma Balance Statement
December 31, 2014
Forecast
Basis % AFN With AFN
2013 2014 Sales Additions 2014 Effects 2014
Cash $ 180,000 0.05 $ 198,000 $ 198,000
Receivables 360,000 0.10 396,000 396,000
Inventories 720,000 0.20 792,000 792,000
Total curr. assets $1,260,000 $1,386,000 $1,386,000
Fixed assets 1,440,000 0.40 1,584,000 1,584,000
Total assets $2,700,000 $2,970,000 $2,970,000

Accounts payable $ 360,000 0.10 $ 396,000 $ 396,000

Notes payable 156,000 156,000 156,000
Line of credit 0 0 +128,783 128,783
Accruals 180,000 0.05 198,000 198,000
Total curr. liabilities $ 696,000 $ 750,000 $ 878,783
Common stock 1,800,000 1,800,000 1,800,000
Retained earnings 204,000 87,217* 291,217 291,217
Total liab.
and equity $2,700,000 $2,841,217 $2,970,000

Deficit = $ 128,783

*See income statement.

Answers and Solutions: 12 - 11

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 SOLUTION TO SPREADSHEET PROBLEMS

12-10 The detailed solution is available in the file Ch12 P10 Build a Model Solution.xls at the
textbook’s Web site.

12-11 The detailed solution for is available in the file Ch12 P10 Build a Model Solution.xls at
the textbook’s Web site.

Answers and Solutions: 12 - 12

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website, in whole or in part.
 Mini Case: 12 - 13
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website, in whole or in part.