Additional Fund, Financing Requirement - Case Study Example

Finance study case Question One: AFN = Required increase in Assets – Spontaneous increase in liabilities – Increase in retained earnings. Increase in sales = 20% x Total sales (1995) = 20% x $56.16 M = $11.232M Increase in assets = $11.232M x = 11.232 x = $5.616M Increase in liabilities = $11.232 x = 11.232 x = $1.862M Increase in retained earnings = profit margin x sales (1996) x (1 – dividend payout ratio) Profit margin (Investopedia) = = = = 0.0628 or 6.28% Earnings per share = = = 1.78 Dividend payout ratio = = = 0.22 Increase in retained earnings = 0.0628 x $67.39M x (1 – 0.22) = $3.301M AFN = 5.616 – 1.862 – 3.301 = $0.453M Question 2: AFN using the percentage of sales method Given sales volume in 1995 = $56.16M; Sales increase in 1996 = $11.232M List of items that vary with changes in the sales volume: Item in statement of financial position Amount as at end year 1995 ($M) Percentage of sales AFN on item due to sales increase ($M) Cash and Securities 1.64 2.9202 0.328 Accounts receivable 4.00 7.1225 0.80 Inventories 4.20 7.4786 0.84 Net fixed assets 18.24 32.4786 3.648 Accounts payable 0.47 0.8369 (0.094) Accrued wages & taxes 0.36 0.6410 (0.072) Retained earnings 5.73 10.2030 (3.2064) w1 Total 34.64 - 2.2436 W1 ($M) Sales revenue for 1996 67.39 Net profit (6.1% of sales) 4.1108 Dividends (22% of net profit) (0.9044) Retained profits for 1996 3.2064 Expert Systems Inc. Proforma Statement of the Financial Position as at 31st December, 1996 $M $M $M Net fixed Assets (3.468 +18.24) 21.708 Current Assets: Cash & securities (1.64 + 0.328) 1.968 Inventories (4.20 + 0.84) 5.04 Accounts receivable (4.00 + 0.80) 4.80 11.808 Current Liabilities: Accounts payable (0.47 + 0.094) (0.564) Accrued wages & tax (0.36 + 0.072) (0.432) Notes payable (0.80) 10.012 31.72 Financed by: Ordinary share capital 13.04 Retained earnings (5.73 + 3.2064) 8.9364 Long-term debt 7.68 AFN 2.2436 31.90 The AFN (Additional fund/financing requirement) computed under the firm’s internal model is less as compared with that computed under the percentage-sales method. This is because under the firm’s model, we did not differentiate as between items that are acquired or incurred for revenue expenditure vis-à-vis those that are acquired or incurred as part of capital expenditure. Long-term liabilities and current liabilities with a formal written agreement e.g. notes payable and bank overdrafts do not vary with changes in sales volume. Secondly, some of the projected ratios provided by the executive management of the firm vary as between the ratios projected as calculated from the historical information in the firm’s books of accounts e.g. the profit margin provided as 6.1% against the computed 6.28% figure and the earnings per share ratio provided as 1.06% against the computed figure of 1.78%. This has an imbalance effect amounting to $0.18M on the pro forma balance sheet of the firm. Question 3: Regression of assets against sales a) The proportionality test holds it is true that total assets increase in the same ratio, as it is evident in the data provided. The total assets in the year 1991 are 12m$ that when compared with the sales for the same year it is realized that it is half the sales, which implies that sales for the same year is 24m$. Therefore, the proportionality ratio is two. Taking the sales for the year 1992 which is 28.8m $ compared to total assets which is 14.4m $ it implies the same ratio has been maintained. Checking the other sales for the other three subsequent years compared to the total assets it can be summarized from the data the financial increment in assets is two per dollar. The graph below show a straight line graph implying an equal proportionality in the total assets and sales. From the graph, an equation is derived y=2x meaning that for every total asset there is twice sales made. b) Regression analysis From the regression analysis the proportionality test holds but not with the same ratio. This can be witnessed from the graph above. The financial increment ratio is approximately 1.4m per dollar. For any data to be directly proportionally with an exact ratio, the resultant graph always bears a straight line. c) The later situation holds for most companies or firms because the first condition assumes other financial factors. It is only in a perfect condition that firms’ sales will perfectly be proportional to the total sales in every financial year. Its implication if one uses the percentage of sales method is that sales compared to assets will vary. Question 4 The effects of operating fixed assets in 1995 at 80% to the succeeding year will be that there will be a decrease in the total fixed assets by 20 percent implying a decrease in hence reduction of capital, which means a subsequent decease in capital in 1996. To have a balanced situation, adjustments should be made on capital by addition of capital by twenty percent. Question 5: Excess funds can be primarily used for either: a) To invest in marketable securities or other viable projects b) To reduce outstanding debt balances in light of the firm’s heavy use of debt capital. c) To increase compensating balances with its bank(s) d) To provide additional dividends. Question 6 a) Using the same model for question 4, capacity being worked out at 90%, the additional needed funds will be more compared to when the fixed assets are worked out at 80%. The AFN is also spread evenly over the five years. If this method is not employed, there will be variation in the AFN for each year. b) Relationship between projected capital and utilization capacity In case of lumpy capital, the utilization capacity will be low and in a lumpy capital, the capacity of utilization will be maximized. c) data is provided in the spreadsheet Question 7: Factors influencing the financing requirement of a firm include: a) Profitability. In general, profitability can be seen within the financing requirement as the maximum use of debt (within certain constraints) at the lowest cost to the firm. b) Dividend policy. The dividend policy is critical in determining the optimal capital structure of the firm. Shareholders need be compensated to satisfy their expectations over the success of the firm as well as to make the stock of the firm attractive in the secondary market. A steady dividend policy during periods of low growth may drain the firm’s resources but help built its reputation too. c) Capital intensity (see discussion in 11 below) Question 8: Assumptions held under the percentage of sales forecast method include, Firstly, the company is operating profitably. Projections of a sales increase with the distributive effects of dividend and share growth can only be achieved if the firm is operating profitably. Secondly, that the company does not pay out all the earnings available to its ordinary shareholders as dividends. Thirdly, that the firm is operating at full capacity. A most fundamental assumption is the linear relationship between items in the statement of financial position and sales revenue. Other assumptions are that both the inflation level and corporate tax regimes do not change over the forecasted period and we also ignore the time value for money concept. Question 9: Other methods of financial forecasting include, The use of cash budgeting, operating cycle method, trend methods and linear regression analysis. Under cash budgeting, only cash items are included. Non-cash items like depreciation or provisions for doubtful debts are usually ignored. The method concentrates on cash flows from operations in and out of the firm. During the forecasting period, the payments of the firm are netted off the receipts and the surplus/ deficit gets carried forward to the start of the next period. Cash sales, the primary source of cash receipt data is differentiated as between cash and credit sales. Discounts, commissions and overdraft facility are adjusted for under the relevant headings of either receipts or payments. According to the manufacturing/operation cycle method, a defined estimation of the duration of conversion of raw materials into finished goods as well as the stock and debtor holding period is necessary i.e. working capital operating cycle. This method considers additional factors of credit control apart from cash. Question 10 The presence of excessive debt does not necessarily indicate that the capital structure of the firm is out of balance to the extent to which the weighted average cost of that debt plus capital is well below the firm’s expected/required rate of return (Expert Systems, Inc.: Financial Analysis and Forecasting - Case 52, Directed.). However, it is critical to note that such a high leverage ratios indicative of excessive use of debt threatens the solvency of the firm. Similarly, despite the higher rate of return on assets financed by debt as against their cost, the earnings per share will increase without necessarily translating to an increase in the owner’s investment. This is also applicable to assets financed through preference share capital since interest paid on debt is charged against pre-tax profits while preference dividends are non-taxable. Common shareholders, as true owners of the firm stand to lose more in such capital structures. Question 11 A relationship between change in a firm’s capital structure and the value of a firm has yet to be conclusively established. Under the optimal capital structure model, a positive relationship was reported between firm leverage and its value. This was accredited to the incidence of tax shield on corporate debt (Masulis).Other forms of capital structure changes can be in the form of issuer exchange offers and recapitalization. Studies by Miller-Modigliani showed a positive relationship between stock price and firm value to both debt and leverage levels. The earnings per share has an inverse relationship with the stock price such that any changes in the capital structure should they significantly affect the stock price will be transmitted to the share earnings as well. The optimal capital structure equates the firm’s cost of capital (weighted average cost of capital) to the prevailing interest rates in the money market. This discount rate is critical in assessing and selecting between different financing actions of the firm. Changes in the prevailing interest rates will see the firm either adjust its capital structure appropriately to hedge or take advantage of fluctuations within the money market. Question 12: Comparing financial ratios: Ratio Formula 1995 1996 Profit margin = 0.0613 = 0.0628 ROE = 0.2638 = 0.3244 EPS = $1.45 = $1.7841 Current ratio = 6.0368 = 3.5765 Price-earnings ratio before forecast = = = 3.7931 All the ratios under observation show an increase as between the two consecutive years except for the current ratio which registered a decline. This is a point of concern for the executives of the firm as it basically means that the liquidity position of the firm is reducing. Should the trend persist then the firm might find itself with difficulties meeting the operational expenses as they fall due. Works Cited "Expert Systems, Inc.: Financial Analysis and Forecasting - Case 52, Directed." South-Western, 1998. Investopedia. Investopedia. n.d. 29 February 2012 . Masulis, Ronald W. "The Impact of Capital Structure Change on Firm Value: Some Estimates." Journal of Finance (1983): 107. Read More