PART (A)

1. chapter 4 : Mini case study ( Planning for growth at S&S Air):

Answer:

1. To calculate the internal growth rate, we first need to find the ROE and the retention ratio, so:

ROE = NI / TA

ROE $1,537,452/ $18,308,920

ROE = 0.0839 or 8.39%

b = Addition to RE / NI

b = $977,452 / $1,537,452

b = 0.635 or 63.5%

Now we can use the internal growth rate equation to get :

Internal growth rate = (ROA*b) / {1-(ROA*b)}

Internal growth rate = {0.0839(0.635)}/{1-(0.0839(0.635)}

Internal growth rate = 0.0562 or 5.62%

To find subtainable growth, we need to the ROE, which is :

ROE = NI/TE

$1,537,452/$10,069,920 = 0. 1526 or 15.26%

Using the retention ratio we previousely calculated, the subtainable growth rate is :

Subtainable growth rate = (ROA*b) / {1-(ROA*b)}

Subtainable growth rate = 0.1526(0.635)}/{1-(0.1526(0.635)}

Subtainable growth rate = 0.1072 or 10.72%

The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. On the other hand subtainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earning and current capital structure.

2. The external financing required for 12% sales growth assuming full capacity utilization:

EFN= change in Asset – change in liabilities – change in retained earning- Change in asset = 0.12*18,308,920 = 2,197,070- Change in liabilitiea = 0.12 * 889,000 = 106,680- Change in Ret. Earn. = (30,499,420 – 22,224,580 – 3,867,500)* 1.12 –

1,366,680 = 3,569,541

EBT(1) = EBIT(1) – I = 3,569,541 – 478,240 = 3,091,301

Chge. Ret. Earn. = EBT* (1- t) * (b) = 3,091,301 * (1-.40) * .6358 = 1,179,270

- EFN = 2,197,070 – 106,680 – 1,179,270 = 911,120

Let’s look at the pro-forma statements to verify our EFN result.

Pro forma Income statement (12% growth rate)

Income statement

Sales $ 34,159,350

COGS 24,891,530

Other expenses 4,331,600

Depreciation 1,366,680

EBIT $ 3,569,541

Interest 478,240

Taxable income $ 3,091,301

Taxes (40%) 1,236,520

Net income $ 1,854,780

   

Dividends $ 675,583

Add to RE 1,179,197

Pro forma balance sheet ( 12% growth rate)

Balance sheet

Assets   Liabilities & Equity Current Assets     Current Liabilities   Cash $ 493,920   Accounts Payable $ 995,680

Accounts rec. 793,408   Notes Payable 2,030,000

Inventory 1,161,574   Total CL $ 3,025,680

Total CA $ 2,448,902      

      Long-term debt $ 5,320,000

       

  Shareholder Equity  

      Common stock $ 350,000

Fixed assets     Retained earnings 10,899,117

Net PP&E $ 18,057,088     Total Equity $ 11,249,117

         

Total Assets $ 20,505,990   Total L&E $ 19,594,797

So, the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $20,505,990 – 19,594,797

EFN = $911,193 (a small difference due to rounding error)

3. Let us assume that the company can only build in amounts of $5 million. We will

assume that the company will go ahead with the fixed asset acquisition. In this

case, the pro forma financial statement calculation will change slightly. Before,

we made the assumption that depreciation increased proportionally with sales,

which makes sense if fixed assets increase proportionally with sales. This is not

the case now. To estimate the new depreciation charge, we will find the current

depreciation as a percentage of fixed assets, then, apply this percentage to the new

fixed assets. The depreciation as a percentage of assets this year was:

Depreciation percentage = $1,366,680 / $16,122,400

Depreciation percentage = .0.0847 or 8.47%

The new level of fixed assets with the $5 million purchase will be:

New fixed assets = $16,122,400+ 5,000,000 = $21,122,400

So, the pro forma depreciation as a percentage of sales will be:

Pro forma depreciation = .0847($21,122,400)

Pro forma depreciation = $1,789,067

Income statement

Sales $ 34,159,350

COGS 24,891,530

Other expenses 4,331,600

Depreciation 1,789,067

EBIT $ 3,147,153

Interest 478,240

Taxable income $ 2,668,913

Taxes (40%) 1,067,565

Net income $ 1,854,780

   

Dividends $ 675,583

Add to RE 1,179,197

The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The fixed asset account will increase by $5 million, rather than the growth rate of sales.

Balance sheet

Assets   Liabilities & Equity Current Assets     Current Liabilities   Cash $ 493,920   Accounts Payable $ 995,680

Accounts rec. 793,408   Notes Payable 2,030,000

Inventory 1,161,574   Total CL $ 3,025,680

Total CA $ 2,448,902      

      Long-term debt $ 5,320,000

       

  Shareholder Equity  

      Common stock $ 350,000

Fixed assets     Retained earnings 10,737,439

Net PP&E $ 21,122,400   Total Equity $ 11,249,117

         

Total Assets $ 23,571,302   Total L&E $ 19,433,119

So, the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $23,571,302 – 19,433,119

EFN = $4,138,183

Because fixed assets increase more rapidly, the depreciation expense will increase at a

rate that is faster than sales growth.

Sales, profits and retained earnings contribute proportionately less to the total financing

required (Ret. Earn. declines), and

Liabilities (spontaneous liability growth) will contribute less to the total financing required.

So, EFN has to increase