CF 2-2A – EFN with excess production capacity – Corporate Finance

Let's examine problem 22A more on external financing needed. This time we may or may not need to buy some new fixed assets. And that's sort of the extra dilemma, the extra wrinkle thrown in here. Here we go. Fisher company's financial statements are below and we got an income statement and a balance sheet. And it says the company expects sales to grow by 40% next year. So I'm going to have to recast the income statement with 40% sales growth. It says it's going to have a 25% payout ratio, dividend payout ratio, and all costs, current assets, current liabilities are expected to increase with sales. Implying long-term debt, equity, and net fixed assets are not. So let's read on. It says assuming company is operating at 65% capacity usage for fixed assets, compute the external financing needed. And also at 95% will be our second part, but let's start with the income statement. That should be easy here because 40% sales growth and 40% cost growth just means multiply everything by 1.4, right? This is all plus 40%. So 7,500 adding 40%, we multiply by 1.4, we get 10,500, 7,300. Times 1.4, we get 10,220, 10,500 minus 10,220 is 280. That also happens to be income before taxes times 1.4, 60 times 1.4 gives us 84. And again, taxes are 30% of income before taxes. So 280 times 0.3, it's also 84 net income 280 minus 84, our new net income here is 196. Okay. We've projected our income statement. That'll be the same in both scenarios because we're only worried about capacity of fixed assets and that's going to create some potential borrowing. But let's let's go on to project our balance sheet. And we're given that current assets and current liabilities are going to go up by 40% in this scenario. They vary with sales. So sales are up 40%. We're going to need 40% more working capital for a lack of a better word. So 2,000 times 1.4, 2,800 and 1,500 times 1.4 is 2,100. Okay. Now the million dollar question before we can solve for the equity. Well, we could do the equity if we wanted, but before we do that, let's do net fixed assets. We have enough information to do that as well. The question says the company's operating at 65% of capacity with its fixed assets. So we got to answer the question, do we need to borrow or not borrow by any new fixed assets? Do I need new fixed assets to sort of fill a 40% increase? Well, very simple calculation. We're at 65% of our maximum. And now it's saying we want to increase by 40%. Production's got to go up by 40%. Presumably we need 40% more assets. Well, if production goes up by 1.4 times 40% more, where am I at? 0.65 times 1.4. I'm at 91% of capacity. So if I go from using my assets, 65% to 90%, do I need to buy new ones? The answer is no. I mean, we might have to replace or repair some, but no, we don't need to buy any new ones. We're, we're operating at 60% capacity. Maybe we're operating, you know, two shifts and now we can just add a shift, but still use the same asset. So no, I don't need to buy any new assets. That means my net fixed assets can remain at 4,000. So 2,800 plus 4,000 is 6,800. My total liabilities and equity then will be 6,800 in this scenario. Uh, we can solve also for equity. Remember equity is beginning equity plus net income. I like to subtotal it here. Minus dividends equals ending equity. So our beginning equity was 2,000. We're going to add net income. Our projected net income is 196. So I get 2,196. This would be my equity if I didn't pay a dividend, but I do pay a dividend. We have a 25% dividend payout, uh, next year. So 25% of net income. So 196 times. Uh, 25% gives us, I always double underline that gives us a dividend of 196 times 0.25 of 49 bucks. So I'm going to deduct $49 to get my ending equity to 196 minus 49. Uh, 2,147 there's our ending equity. So our ending equity here, 2,147. Now it's just a plug, right? Now we're plugging for our long-term debt and that's going to help us figure out the external financing needed. Uh, I just go 6,800 minus the two above minus 2,100 minus 2,147. That's going to solve it for 6,800 minus 2,100 minus 2,147. It gives us 2,553. So are we going to need to borrow some new money? Yes, but not much. Like I wouldn't be super worried if this was my projected, my projection, my EFN is a 2,553 minus 2,500. I'm going to need $53 a thousand or million, right? These are often in big numbers, but I'm going to need $53 in new financing, according to this calculation. Okay. Now we're asked to do the exact same thing, except this time we're at 95% capacity. Let's see if I can get, uh, I'm just going to solve in the same spot, but with a different color ink. See how I do with some, uh, maybe green ink. What do you think? Green? How's this look? Hello? Yeah, that looks okay. Maybe a little bit thick. Let me make it a little thinner and we'll solve. Yeah, that's perfect. Okay. So I'm going to solve in green ink, the exact same problem. In fact, I don't need to do anything here. The income statement is the same. The balance sheet though, my current assets, they grow by 40%. My current liabilities, they grow by 40%. Uh, let's look at what happens to net fixed assets. That's the key to the whole puzzle. That's the new thing. And let's think about this. We are at 95% capacity now, and we're going to grow by 1.4 times. 95% times 1.4 times growth. 40% growth is going to put us at my calculator. Oh, there it is. Uh, 0.95 times 1.4. It's going to put us at 1.33X capacity. Meaning I got to grow my fixed assets by 1.33 times. So let's do that. We have $4,000 in fixed assets. I want them to go up by 1.33 to 5,320. Our new total assets, then 2,800 times times plus 2,800 plus 5,320 is 8,120. Now it's all the same math on the other side. We just have to sort of redo it. Uh, our current liabilities are 2,100 same as before our equity. Same as before. So it's going to be a beginning equity 2000, just as it was our net income, because our income savings are the same is the same, our dividend payout ratio remains the same. So our ending equity is still 2,147. In this new scenario, we've just got a plug. We know our total assets now are 8,120. They're higher, right? Than the new total assets. So our total liabilities and equity has to match that has to be 8,120. So we're going to have a whole bunch of new borrowing. 8,120 minus 2,147 minus 2,100 gives us our new borrowing needs. 3,873, 3,873 is our missing number there. So under this scenario, our EFN is, uh, 3,873 is our new, uh, debt. Our old debt was 2,500. So our new borrowing, our external financing needed here is 1,373. Um, this is significant, right? Especially if these are in thousands or millions of dollars, you're thinking, my God, I got to borrow so much money to, uh, uh, meet my needs to, if I want to grow like this, I'm going to need a lot of new assets. And if I need a lot of new assets, I'm going to need to borrow a lot of money. Uh, my external financing needed here is 1,373. And again, that's a problem or a challenge for the manager to make sure they have the capacity to borrow that much. And if they don't, they better change their plans. Okay. That's it for this video. Stay tuned for the next one. Bye for now. And thanks for watching. Bye-bye.