FINVRAJ PRACTICE QUESTIONS (AFN FORMULA)

AFN and current ratio

1. Snowball & Company has the following balance sheet:

Current assets R 7,000 A/P & Accruals R1,500

Fixed assets 3,000 S-T (3-month) Loans R2,000
Common Stock R1,500
Ret. Earnings 5,000
Total assets R10,000 Total claims R10,000

Snowball's after-tax profit margin is 11 percent, and the company pays out 60
percent of its earnings as dividends. Its sales last year were R10,000; its assets
were used to full capacity; no economies of scale exist in the use of assets; and the

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profit margin and payout ratio are expected to remain constant. The company uses

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the AFN equation to estimate funds requirements, and it plans to raise any required

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external capital as short-term bank loans. If sales grow by 50 percent, what will
Snowball's current ratio be after it has raised the necessary expansion funds?

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SOLUTION rs e
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Formula solution
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Step 1 AFN = A*/S0(∆S) - L*/S0(∆S) - M(S1)(1 - d)

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R10,000 R1,500
= (R5,000) - (R5,000) - 0.11(R15,000)(1 - 0.6)
R10,000 R10,000

= 1(R5,000) - 0.15(R5,000) - 0.11(R15,000)(0.4)

ed d
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= R5,000 - R750 - R660 = R3,590.

Step 2 Current assets will increase to R7,000/R10,000 × R15,000 = 10,500.

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Current liabilities will increase to:

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R1,500
A/P + Accruals = × R15,000 = R2,250
R10,000

S-T Debt = R2,000 + R3,590 = 5,590

Total C.L. = R7,840

New current ratio will be R10 500/R7 840 = 1.34 times.

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 Question 2

Jackson Co. has the following balance sheet for the most recent year (as of
December 31).
Assets: Claims:
Current assets R 600,000 Accounts payable R 100,000
Fixed assets 400,000 Accruals 100,000
Notes payable 100,000
Total current liabilities R 300,000

Long-term debt 300,000

Total equity 400,000
Total assets R1,000,000 Total claims R1,000,000

During the most recent year, the company reported sales of R5 million, net
income of R100,000, and dividends of R60,000. The company anticipates its

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sales will increase 20 percent in the next year and its dividend payout will
remain at 60 percent. Assume the company is at full capacity, so its assets

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and spontaneous liabilities will increase proportionately with an increase in
sales.

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Assume the company uses the AFN formula and all additional funds needed
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(AFN) will come from issuing new long-term debt. Given its forecast, how
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much long-term debt will the company have to issue in the next year?

Solution
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AFN = (A*/S)∆S - (L*/S)∆S - (M)(S1)(RR). A* = R1,000,000 because the firm is at total capacity. (The
firm will need to increase fixed assets as well as current assets.)
vi y re

Sales = R5,000,000.

∆S = R5,000,000 × 20%
ed d

= R1,000,000.
ar stu

L* = R100,000 + R100,000 = R200,000. Only the accounts payable and accruals are
spontaneous liabilities. (Notes payable are not.)
sh is

d = 60%; so RR = (1 - 0.6) = 0.4 or 40%.

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M = NI/Sales
= R100,000/R5,000,000
= 2%.
S1 = R5,000,000 × 1.2
= R6,000,000.

AFN = (A*/S)∆S - (L*/S)∆S - (M)(S1) (RR)

= (R1,000,000/R5,000,000)(R1,000,000) - (R200,000/R5,000,000)
(R1,000,000) - (0.02)(R6,000,000) (0.4)
= R200,000 - R40,000 - R48,000
= R112,000.

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 Changing credit standards

Question 1

East Gate Appliances (EGA) expects to have sales this year of R15 million under its current
credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and
the bad debt loss percentage is 5 percent. Since EGA wants to improve its profitability, the
treasurer has proposed that the credit period be shortened to 15 days. This change would
reduce expected sales by R500,000, but it would also shorten the DSO on the remaining sales
to 30 days. Expected bad debt losses on the remaining sales would fall to 3 percent. The
variable cost ratio/percentage is 60 percent, and the cost of capital is 15 percent.

(a) What would be the incremental bad losses if the change were made?
(b) What would be the incremental cost of carrying receivables if this change were made?

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(c) What are the incremental pre-tax profits from this proposal?

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Solution

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(a) Bad debt losses old: (.05) (R15, 000,000) = R750, 000.

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Bad debt losses new: (.03) (R14, 500,000) = R435, 000.
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Change in bad debt losses = R435, 000 - R750, 000 = -R315,000. (profit)

(b) DSO0 = 60 days; DSON = 30 days. No discounts.

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Calculate cost of carrying receivables at current and new sales levels:

vi y re

Cost of carrying
receivables = DSO (Sales/Day) (Variable cost ratio) (Cost of funds)
ed d

Sales at R15, 000,000: 60(R15, 000,000/360) (0.6) (0.15) = R225, 000.

ar stu

Sales at R14, 500,000: 30(R14, 500,000/360) (0.6) (0.15) = R108, 750.

Change = R108, 750 - R225, 000 = -R116, 250.

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(c) Analysis of policy change:

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Current Effect of Credit New

Projections Policy Change Projections

Net sales R15,000,000 -R500,000 R14,500,000

Production costs 9,000,000 + 300,000 8,700,000

Profit before

credit costs R 6,000,000 -R200,000 R 5,800,000

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 Cost of carrying

receivables 225,000 + 116,250 108,750

Bad debt losses 750,000 + 315,000 435,000

Pre-tax profits R 5,025,000 +R231,250 R 5,256,250

Change in incremental pre-tax profits = R231, 250.

Question 2

Berkeley Prints expects to have sales this year of R15 million under its current credit policy. The
present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss
percentage is 5 percent. Also, Berkeley’s cost of capital is 15 percent, and its variable costs total 60
percent of sales. Since Berkeley wants to improve its profitability, a proposal has been made to offer a 2
percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The

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consultants predict that sales would increase by R500, 000, and that 50 percent of all customers would

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take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales

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would fall to 4 percent.

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Required

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iWhat would be the cost to Berkeley if the discounts taken?
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ii. What would be the incremental bad debt losses if the change were made?

iii. What would be the incremental cost of carrying receivables if the change were made?
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iv. What are the incremental pre-tax profits from this proposal?
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ed d

i.
No discounts with old policy; 2% discount with new policy (2/10, net 30)
ar stu

Discount = R15,500,000(0.5)(0.02) = R155,000.

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ii.
Th

Bad debt losses old: (0.05)(R15,000,000) = R750,000.

Bad debt losses new: (0.04)(R15,500,000) = R620,000.

Changes in bad debt losses = R620,000 - R750,000 = -R130,000.

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 iii.
DSO0 = 60 days; DSON = 30 days.

Cost of carrying
receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds)

Sales at R15,000,000: 60(R15,000,000/360)(0.6)(0.15) = R225,000.

Sales at R15,500,000: 30(R15,500,000/360)(0.6)(0.15) = R116,250.

Change = R116,250 - R225,000 = -R108,750.

iv.
Analysis of policy change:

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Current Effect of Credit New

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Projections Policy Change Projections
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Sales R15,000,000 +R500,000 R15,500,000

Discounts 0 - 155,000 155,000

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Net sales R15,000,000 +R 345,000 R15,345,000

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Production costs 9,000,000 - 300,000 9,300,000

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Profit before

credit costs R 6,000,000 +R 45,000 R 6,045,000

ed d
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Cost of carrying

receivables 225,000 + 108,750 116,250

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Bad debt losses 750,000 + 130,000 620,000

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Pre-tax profits R 5,025,000 +R 283,750 R 5,308,750

Change in incremental pre-tax profits = +R283, 750.

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