Unformatted text preview: FINC 202 Lecture 16
Additional Funds Needed (AFN) Equation Model 1 The (Direct) AFN Model
Additional Funds Needed Spontaneous Increase = Required − − Increase Increase in in in Assets Liabilities Retained Earnings A0 * L0 * ( ∆S ) − ( ∆S ) − MS1 (1 − d ) AFN = S0 S0 2 Key:
A0*/S0 = Required rate of change of A* type Assets per $1 change in Sales L0*/S0 = Required rate of change of L* type Liabilities per $1 change in Sales S1 = Next period’s projected Sales ∆ S = S1 S0 = _______________________________ M = Profit Margin = Rate of Profit per $1 of Sales ie: (NPAT/S) d = Dividend Payout Rate = % of NPAT paid out as Dividends 3 Note:
Textbook uses final term in equation: MS1(RR) Where RR = (1 – d)
Retention Ratio 4 Problem 1: Addis Ltd – Problem
A* = CA + NFA = ( 20 + 240 + 240 ) + 500 = 1, 000
AFN = ? Compute by the AFN Equation Method But this time let M=NPAT/Sales L* = Accounts Payable + Accruals = $100 M = 2.52% S1 = S0 ×1.25 = 2, 000 ×1.25 = $2,500 and d = 30% ∆S = S1 − S0 or... ∆S = S0 × 0.25 = 2, 000 × 0.25 = 500
5 = 2,500 − 2, 000 = 500 * A0 L* AFN = ∆S − 0 ∆S − ( M ) ( S1 ) ( 1 − d ) Solution 1: Addis Ltd: S0 S0 = 6 . Equation AFN = $181 vs. $179. Equation Why the $2 difference? Why M = 0.026 would furnish an AFN2010 of $179.5 • This yields the NPAT2010 = $65 and (1d) =$46 when each is rounded to the nearest dollar These were the POS method figures • But M = 0.026 ignores adjustment to: the size of interest expense in the proforma income statement The size of Notes Payable and Longterm Debt in the 1st approximation of the balance sheet But the actual M = 0.025, • Which yields an AFN2010 of $181.25 (not the assumed 0.0252) 7 Better to use the calculated 0.025 rather than an assumed 0.0252 Underlying issues that might cause the $2 Underlying difference difference • Equation method assumes a constant profit margin, a constant dividend payout, and a constant capital structure. We get an approximation that builds in some degree of allowance for feedback effect • i.e., change in interest expense in the underlying income statement • Financial statement method is more flexible. More important, it allows different items to grow at different rates. But we __________________________________________. 8 • • Model estimates AFN directly using AFN Model: Uses, Assumptions, & AFN TASK TASK
projected change in sales revenue corresponding changes in A*, L* and RE A, L proportional to sales (Call them A*, L*) production at full capacity ratios remain constant. If not, ditch model Assumptions: Problem 2: Apply model to Bison Ltd
If growth in Sales = 10% If growth in Sales = 25% 9 Solution 2: Solution Percentage growth in Sales = 10% Percentage
* A0 L* AFN = ∆S − 0 ∆S − ( M ) ( S1 ) ( 1 − d ) S0 S0 = 10 . Solution 2: Solution Percentage growth in Sales = 25% Percentage
* A0 L* AFN = ∆S − 0 ∆S − ( M ) ( S1 ) ( 1 − d ) S0 S0 = . 11 Limitations of AFN Equation Method
• •
POS method implies proportional relationship between A, L and sales Two key exceptions are scale economies _______________________________ 12 Economies of scale
Efficiencies of size means that assets do not need to rise as fast as sales.
turns over faster For a 10% rise in Sales, maybe inventory rises 4% but Inventory $ 300 180 Base Stock Sales $ 200 400 13 Lumpy assets
Lumpy assets create excess capacity until sales reach point where capacity is reached. Fixed Assets $ FAEMPLOYED Sales Sales $ 14 Full Capacity v Excess Capacity with respect to the AFN Equation: with
• • •
Excess capacity occurs with lumpy assets Start with A* argument at Full Capacity utilization: A* argument can be separated into CA* and NFA* arguments: But first … CA + NFA = A* at full capacity A0 * CA0 NFA0 ( S1 − S0 ) = ( S1 − S0 ) + ( S1 − S0 ) S0 S0 S0 15 • When there is excess capacity: NFA is __________________________ But CA assumed to be at full capacity • CA can be adjusted relatively quickly • The asset arguments become: A0 * CA0 NFA0 ( S1 − Scap ) ( S1 − S0 ) = ( S1 − S0 ) + S0 S0 S cap 16 S0 Scap S1 NFA utilized 100% 17 How to deal with Lumpy Assets • The new term to be included in the AFN equation: ∀ ∆ NFA = Addition to Net fixed Assets ∆ NFA now no longer handled by A* NFA0 ( Sales1 − SalesCapacity ) ∆NFA = SalesCapacity 18 How to work out full Capacity Level of Sales Current Sales Capacity Sales = % of Fixed Assets Operated
Example: Let S0 = $100 Let current operations be at 80% of Fixed Asset capacity 19 Full equation incorporating excess Full capacity now is: capacity A0 * NFA0 L0 * ( S1 − Scap ) − ( ∆S ) − MS1 (1 − d ) ( ∆S ) + AFN = S0 S cap S0 20 Problem 3: Addis Ltd currently at 90% Problem of Capacity of
∆S = S1 − S0 = 2,500 − 2, 000 = 500
L* = Accounts Payable + Accruals = $100 M = 2.52% S1 = S0 ×1.25 = 2, 000 ×1.25 = $2,500 and d = 30% or... ∆S = S0 × 0.25 = 2, 000 × 0.25 = 500
A* = CA* = 20 + 240 + 240 = 500
AFN = ? Compute by the AFN Equation Method with extra NFA argument 21 Solution 3
S0 SCAP = 0.8 2, 000 = 0.9 = S1 − SCAP = 2,500 − = 22 . Sol 3 Sol cont’d cont’d A0 * NFA0 AFN = ( ∆S ) + ( S1 − Scap ) S0 Scap L0 * − ( ∆S ) − MS1 ( 1 − d ) S0 = . 23 The Sensitivity of the AFN Model The (Ignoring Lumpy Assets) (Ignoring • Model can evaluate sensitivity of AFN to sales growth dividend payout ratio net profit margin • Test these out by changing value of _________________________
24 Sales Growth and AFN
The higher the growth rate in sales, the greater the AFN. AFN line would pass through origin only if dividend payout ratio was 100% AFN $$ Sales Growth Rate % 25 Capital Intensity and AFN
The capital intensity ratio is the amount of assets required per $1 of Sales The higher the capital intensity, the greater the AFN. AFN $$ With low A*/S Sales Growth Rate % 26 Factors Affecting the Capital Intensity Ratio A*/S 1. 2. 3. • • • Inventory and Production Policy Inventory Turnover ratio ⇑ ⇒ A*/S ⇓ Inventory Collection Period ⇑ ⇒ A*/S ⇑ DSO ⇑ ⇒ A*/S ⇑ The closer to capacity, the cheaper the investment in FA becomes per dollar of sales • As less slack capacity has to be carried per dollar of sales Depends on which is more expensive per dollar of sales 27 Credit Policy Degree of Fixed Asset capacity utilization 4. • Labour __________________________ NB: L*/S affected by 1. • Suppliers’ credit policies Do they offer an attractive discount for early payment or not? • If YES then L*/S ⇓ Payables Disbursement Period ⇑ ⇒ L*/S ⇑ • Ie, if creditors are slack we can make use of that by delaying payments 2. • Accounts Payable payment policy 3. • Wage payment policy (weekly v monthly)
If Accrued Wages ⇑ …then L*/S ⇑ 28 Dividend payout ratio and AFN
Affects the availability of Retained Earnings The higher the payout ratio, the smaller the addition to RE and the greater the AFN. AFN $$ AFN0 Sales Growth Rate % 29 Net profit margin M and AFN Net
The higher the Net Profit margin M, the lower the AFN line. (Still linear!)
AFN $$ AFN0 Sales Growth Rate % 30 ...
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 Spring '09
 WarwickAnderson
 Revenue, Generally Accepted Accounting Principles, AFN, Capacity utilization, Dividend cover

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