Compute the change in retain earnings using the formula ∆RE = NI – Div.
The change in retain earnings is added to the beginning RE.
•
EFN is the plug figure to make the balance sheet balance
5
AFN Equation Method
•
AFN (or EFN) Key Assumptions
–
Each type of asset grows proportionately with sales
–
Payables and accruals grow proportionately with sales
–
Operating at full capacity
–
Constant profit margin
–
Constant dividend payout ratio
•
If the fixed asset is operating at less than full capacity, we need to
check what is the capacity sales (i.e., what is the sales figure when
fixed asset is operating at full capacity
•
If the capacity sales are greater than the forecasted sales, no new
fixed assets are needed.
capacity
of
%
sales
Actual
Sales
Capacity
=
6
Cont’d
EFN or AFN = required increase in asset – increase in
spontaneous liability – change in retained earnings
=
(A*/S)
∆
S – (L*/S)
∆
S – MS
1
( 1 – d)
A* = assets that vary directly with sales
L* = liabilities that increase spontaneously with sales
S = original sales
S
1
= total sales projected for next year (based on projection)
∆
S =change in sales (based on projection)
M =profit margin ; d = dividend payout ratio
Where :
7
Cont’d
EFN or AFN = required increase in asset – increase in
spontaneous liability – change in retained earnings
What if EFN is negative?
⇒
Excess funds
8
Internal Growth Rate
•
The max growth rate that can be achieved with no external
financing of any kind.
In other words, retained earnings as the
only source of financing.
In general, Required increase in assets = spontaneous increase
in current liabilities + addition to retained earnings
Since no externally financing EFN = 0, and here we assume
that all liabilities are nonspontaneous:
Required increase in assets = addition to retained earnings
•
If EFN = ve,
⇒
addition to earnings > required increase in
assets
to support the current sales.
The current sales growth
rate is less than the internal growth rate
Internal Growth Rate
9
Cont’d
•
The internal growth rate can be calculated as follows:
b
ROA x

1
b
ROA x
Rate
Growth
Internal
=
Where ROA = return on asset ;
b = retention ratio
10
Sustainable Growth Rate
•
The max growth rate a firm can be achieved with no external
equity financing (i.e., only using retained earnings) while maintain
a constant debttoequity ratio.
Here we assume that the debtto
equity ratio is optimal.
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 Winter '14
 Balance Sheet, Generally Accepted Accounting Principles