week 3 discussion

week 3 discussion - The additional funds needed concept is...

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The additional funds needed concept is used by corporation when they are exploring the option of expanding their business. The thinking is that if a business wants to expand their sales, then they will need more income in the form of assets. The additional funds needed are used to plan for these additional funds needed in the form of new assets (Ehrhardt & Brigham, 2009). The equation is as follows: Additional Funds Needed (AFN) = Projected increase in assets – spontaneous increase in liabilities – any increase in retained earnings The essence of this equation is to find out how much external funding is needed. There are a few points to remember when calculating Additional Funds Needed. Most obviously, the company needs to know if they are operating at full capacity. If they are not at full capacity, then the company can easily expand their sales without needing additional funds in the form of extra equipment, man power, building space, etc. If the Additional Funds Needed is found to be a negative value than this is interpreted as meaning that expanding sales and the additional funds needed to do so would generate extra income that could ultimately be used to pay for the initial investment needed, i.e., the expansion would pay for itself. More technically, the Additional Funds Needed equation can be further dissected into a mathematical formula: AFN = (A*/S 0 )ΔS – (L*/S 0 )ΔS – MS 1 (RR) Where: A* = Assets tied directly to sales and will increase L* = Spontaneous liabilities that will be affected by sales. (NOTE: Not all liabilities will be affected by sales such as long-term debt) S 0 = Sales during the last year S 1 = Total sales projected for next year (the new level of sales). ΔS = The increase in sales between S 0 and S 1 M = Profit margin, or the profit per unit of sales MS 1 = Projected Net Income RR = The retention ratio from Net Income and is also calculated as (1 – payout ratio) (Wikipedia) The equation used to find out if a corporation is operating at full capacity is as follows: where S 0 = Current Sales, S 1 = Forecasted Sales = S 0 (1 + g), g = the forecasted growth rate is Sales, A* 0 = Assets (at time 0) which vary directly with Sales, L* 0 = Liabilities (at time 0) which vary directly with Sales, PM = Profit Margin = (Net Income)/(Sales), and b = Retention Ratio = (Addition to Retained Earnings)/(Net Income)

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(Zenwealth) If the firm is operating at full capacity and is utilizing its assets thusly, then A* 0 will equal Total Assets. There is also the scenario of if the company is operating at excess capacity. If this is the case, then the excess capacity in fixed assets may not need to increase in order to support the expected increase in sales. Ultimately, this means that the additional funds needed would be less than expected when compared to the situation where the fixed assets are being used at capacity (Zenwealth). There are two options to consider when looking at excess capacity.
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This note was uploaded on 12/02/2011 for the course ECON 101 taught by Professor Smith during the Spring '11 term at Ill. Chicago.

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week 3 discussion - The additional funds needed concept is...

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