Mary Mickaella R.

Ventura

BSA 3-A
Chapter 4 p. 112-118 (18-27 only)

1. Growth and Profit Margin [LO3] McCormac Co. wishes to maintain a growth rate of 12 percent a
year, a debt–equity ratio of 1.20, and a dividend payout ratio of 30 percent. The ratio of total
assets to sales is constant at .75. What profit margin must the firm achieve?

Solution:

b = 1 – .30

b = .70

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

.12 = [ROE(.70)] / [1 – ROE(.70)]

ROE = .1531 or 15.31%

ROE = PM(TAT)(EM)

.1531 = PM(1 / 0.75)(1 + 1.20)

PM = (.1531) / [(1 / 0.75)(2.20)]

PM = .0522 or 5.22%

2. Growth and Debt–Equity Ratio [LO3] A firm wishes to maintain a growth rate of 11.5 percent
and a dividend payout ratio of 30 percent. The ratio of total assets to sales is constant at .60,
and profit margin is 6.2 percent. If the firm also wishes to maintain a constant debt–equity ratio,
what must it be?
Solution:
b = 1 – .30
b = .70

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

.115 = [ROE(.70)] / [1 – ROE(.70)]
ROE = .1473 or 14.73%

ROE = PM(TAT)(EM)
.1473 = (.062)(1 / .60)EM
EM = (.1473)(.60) / .062
 EM = 1.43

D/E ratio
D/E = EM – 1
D/E = 1.43 – 1
D/E = 0.43

3. Growth and Assets [LO3] A fi rm wishes to maintain an internal growth rate of 7 percent and a
dividend payout ratio of 25 percent. The current profit margin is 5 percent, and the firm uses no
external financing sources. What must total asset turnover be?
Solution:
b = 1 – .25
b = .75

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

.07 = [ROA(.75)] / [1 – ROA(.75)]
ROA = .0872 or 8.72%

ROA = (PM)(TAT)
.0872 = .05(PM)
TAT = .0872 / .05
TAT = 1.74 times

4. Sustainable Growth [LO3] Based on the following information, calculate the sustainable growth
rate for Hendrix Guitars, Inc.:
Profit margin = 4.8%
Total asset turnover = 1.25
Total debt ratio = .65
Payout ratio = 30%

Solution:
Total debt ratio = .65 = TD / TA
Inverting both sides we get:
1 / .65 = TA / TD

TA / TD = 1 + TE / TD

1 / .65 = 1 + TE /TD

D/E = 1 / [(1 / .65) – 1]

D/E = 1.86
 ROE = (PM)(TAT)(EM)
ROE = (.048)(1.25)(1 + 1.86)
ROE = .1714 or 17.14%

b = 1 – .30
b = .70
Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]
Sustainable growth rate = [.1714(.70)] / [1 – .1714(.70)]
Sustainable growth rate = .1364 or 13.64%

5. Sustainable Growth and Outside Financing [LO3] You’ve collected the following information
about St. Pierre, Inc.:
Sales = $195,000
Net income = $17,500
Dividends = $9,300
Total debt = $86,000
Total equity = $58,000

What is the sustainable growth rate for St. Pierre, Inc.? If it does grow at this rate, how much
new borrowing will take place in the coming year, assuming a constant debt–equity ratio? What
growth rate could be supported with no outside financing at all?

Solution:
b = 1 – $9,300 / $17,500
b = .4686

And the ROE is:

ROE = $17,500 / $58,000
ROE = .3017 or 30.17%

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.3017(.4686)] / [1 – .3017(.4686)]
Sustainable growth rate = .1647 or 16.47%

New TA = 1.1647($86,000 + 58,000) = $167,710.84

New TD = [D / (D + E)](TA)
New TD = [$86,000 / ($86,000 + 58,000)]($167,710.84)
New TD = $100,160.64

Additional borrowing = $100,160.04 – 86,000

Additional borrowing = $14,160.64
 ROA = $17,500 / ($86,000 + 58,000)
ROA = .1215 or 12.15%

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [.1215(.4686)] / [1 – .1215(.4686)]
Internal growth rate = .0604 or 6.04%

6. Sustainable Growth Rate [LO3] Coheed, Inc., had equity of $135,000 at the beginning of the
year. At the end of the year, the company had total assets of $250,000. During the year the
company sold no new equity. Net income for the year was $19,000 and dividends were $2,500.
What is the sustainable growth rate for the company? What is the sustainable growth rate if you
use the formula ROE X b and beginning of period equity? What is the sustainable growth rate if
you use end of period equity in this formula? Is this number too high or too low? Why?

Solution:
Retained earnings = NI – Dividends
Retained earnings = $19,000 – 2,500
Retained earnings = $16,500

Ending equity = $135,000 + 16,500

Ending equity = $151,500

ROE = $19,000 / $151,500

ROE = .1254 or 12.54%

Plowback ratio = Addition to retained earnings/NI

Plowback ratio = $16,500 / $19,000
Plowback ratio = .8684 or 86.84%

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1254(.8684)] / [1 – .1254(.8684)]
Sustainable growth rate = .1222 or 12.22%

ROE = $16,500 / $135,000

ROE = .1407 or 14.07%

Sustainable growth rate = ROE × b

Sustainable growth rate = .1407 × .8684
Sustainable growth rate = .1222 or 12.22%

Sustainable growth rate = ROE × b

Sustainable growth rate = .1254 × .8684
Sustainable growth rate = .1089 or 10.89%
7. Internal Growth Rates [LO3] Calculate the internal growth rate for the company in the previous
problem. Now calculate the internal growth rate using ROA X b for both beginning of period and
end of period total assets. What do you observe?
Solution:
ROA = $19,000 / $250,000
ROA = .0760 or 7.60%

Beginning assets = Ending assets – Addition to retained earnings

Beginning assets = $250,000 – 16,500
Beginning assets = $233,500

ROA = $19,000 / $233,500

ROA = .0814 or 8.14%

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [.0814(.8684)] / [1 – .0814(.8684)]
Internal growth rate = .0707 or 7.07%

Internal growth rate = .0760 × .8684

Internal growth rate = .0660 or 6.60%

Internal growth rate = .0814 × .8684

Internal growth rate = .0707 or 7.07%

8. Calculating EFN [LO2] The most recent financial statements for Moose Tours, Inc., follow. Sales
for 2009 are projected to grow by 20 percent. Interest expense will remain constant; the tax
rate and the dividend payout rate will also remain constant. Costs, other expenses, current
assets, and accounts payable increase spontaneously with sales. If the firm is operating at full
capacity and no new debt or equity is issued, what external financing is needed to support the
20 percent growth rate in sales?
Solution:
 Dividends = ($33,735/$112,450)($136,760)
Dividends = $41,028

Addition to retained earnings = $136,760 – 41,028

Addition to retained earnings = $95,732

New retained earnings = $182,900 + 95,732

New retained earnings = $278,632

The pro forma balance sheet will look like this:

EFN = Total assets – Total liabilities and equity

EFN = $679,080 – 675,232
EFN = $3,848

9. Capacity Usage and Growth [LO2] In the previous problem, suppose the firm was operating at
only 80 percent capacity in 2008. What is EFN now?

Solution:

Full capacity sales = $929,000 / .80

Full capacity sales = $1,161,250

The capital intensity ratio at full capacity sales is:

Capital intensity ratio = Fixed assets / Full capacity sales

Capital intensity ratio = $413,000 / $1,161,250

Capital intensity ratio = .35565

 The fixed assets required at full capacity sales is the capital intensity ratio times the projected
sales

level:

Total fixed assets = .35565($1,161,250) = $396,480

EFN = ($183,480 + 396,480) – $613,806 = –$95,272

This assumes that fixed assets are decreased (sold) so the company has a 100% fixed asset
utilization. If we assume fixed assets are not sold, the answer becomes:

EFN = ($183,480 + 413,000) – $613,806 = –$166,154

10. Calculating EFN [LO2] In Problem 25, suppose the firm wishes to keep its debt–equity ratio
constant. What is EFN now?
Solution:
Debt Equity Ratio:
D/E = ($85,000 + 158,000) / $322,900
D/E = .7526

New total debt = .7526($418,632)

New total debt = $315,044

The new level of accounts payable:

current accounts payable times the sales growth, or:
Spontaneous increase in accounts payable = $68,000(.20)
Spontaneous increase in accounts payable = $13,600

This means that $13,600 of the new total debt is not raised externally. So, the debt raised
externally,
which will be the EFN is:
EFN = New total debt – (Beginning LTD + Beginning CL + Spontaneous increase in AP)
EFN = $315,044 – ($158,000 + 68,000 + 17,000 + 13,600) = $58,444