The most recent income statement and balance sheet for the T. McGraw Corporation
ID: 2664405 • Letter: T
Question
The most recent income statement and balance sheet for the T. McGraw Corporation are as follows.T. McGraw Corporation
Income Statement
Sales $10,000
Costs 7,500
Taxable income $ 2,500
Taxes (34%) 850
Net income $ 1,650
Retained earnings $ 660
Div $ 990
Balance Sheet
Current assets $5,000 Total debt $6,000
Fixed assets $10,000 Owner’s equity $9,000
Total $15,000 Total $15,000
McGraw is forecasting a 20% increase in sales for the coming year. Assets increase directly with sales, while liabilities and equity do not increase directly with sales.
1.Compute the following for McGraw.
1.profit margin (p)
2.retention ratio (R)
3.return on assets (ROA)
4.return on equity (ROE)
5.debt/equity ratio (D/E).
2.Use the ratios computed in a) above to calculate the external financing required by T. McGraw.
3.Use the pro forma statements to verify the results in the solution to b) above.
4.Use the solution to a) above to determine the growth rate McGraw can maintain if no external financing is used.
5.Use the linear equation developed in the solution to d) above to determine the external financing needed for a growth rate equal to zero. In addition, determine EFN for a growth rate of 1% and a growth rate of 10%.
6.Use the data from the solution in a) above to determine the sustainable growth rate for McGraw.
7.Use the Du Pont identity to verify the calculations in the solution to f) above.
8.Verify the results in the solutions to f) and g) above by preparing the pro forma income statement and balance sheet for McGraw, using the 7.914% sustainable growth rate.
Explanation / Answer
a. Compute the following for McGraw.
PM
=
$1,650/$10,000 = 16.5%
R
=
$660/$1,650 = 40%
ROA
=
$1,650/$15,000 = 11%
ROE
=
$1,650/$9,000 = 18.333%
D/E
=
$6,000/$9,000 = 66.667%
b. Use the ratios computed in a) above to calculate the external financing required by T. McGraw.
The increase in assets to be financed is: $15,000 × .20 = $3,000. To calculate the financing available in the form of retained earnings, we first calculate projected sales:
Sales × (1 + g) = $10,000 × 1.20 = $12,000
Projected net income equals profit margin times projected sales: .165 × $12,000 = $1,980. The projected addition to retained earnings is the retention ratio times projected net income:
.40 × $1,980 = $792
Hence, the external financing needed is: EFN = $3,000 - $792 = $2,208.
Use the pro forma statements to verify the results in the solution to b) above.
The pro forma statements appear in the problem and are thus not repeated here.
Use the solution to a) above to determine the growth rate McGraw can maintain if no external financing is used.
From the solution to Part B, EFN = -$660 + ($14,340 × g). Now we verify the growth rate the firm can achieve without external financing, by setting EFN equal to zero and solving for g: EFN = -$660 + ($14,340 × g)
g = $660/$14,340 = .04603 = 4.603%
Use the linear equation developed in the solution to d) above to determine the external financing needed for a growth rate equal to zero. In addition, determine EFN for a growth rate of 1% and a growth rate of 10%.
External financing needed and growth is obviously related. All other things equal, the higher the rate of growth in sales or assets, the greater the need for external financing.
EFN = -$660 + ($14,340 * g)
Growth rate (g) = $660 / $14,340
Growth rate (g) = 0.04603 (or) 4.603%
Calculating External Financing Needed (EFN) for a growth rate of 0%:
EFN = -$660 + ($14,340 * 0%)
EFN = -$660 + $0
EFN = -$660
Calculating External Financing Needed (EFN) for a growth rate of 1%:
EFN = -$660 + ($14,340 * 1%)
EFN = -$660 + $143.40
EFN = -$516.60
Calculating External Financing Needed (EFN) for a growth rate of 10%:
EFN = -$660 +($14,340 * 10%)
EFN = -$660 + $1,434
EFN = $774
c. Use the data from the solution in a) above to determine the sustainable growth rate for McGraw.
The sustainable growth rate, g*, equals (ROE × b)/(1 - ROE × b), or
g* = [(.18333)(.40)]/[1 - (.18333)(.40)] = .07914 = 7.914%.
For that reason, T. McGraw Corporation can grow at a rate of 7.914% without issuing new equity.
d. Use the Du Pont identity to verify the calculations in the solution to f) above.
Considering the Du Pont identity, ROE equals Profit margin × Total asset turnover × Equity multiplier, substituting the data for T. McGraw from Problem 3:
ROE = .165 × ($10,000/$15,000) × [1 + ($6,000/$9,000)] = .18333
Sustainable growth rate equals (.1833 × .4)/(1 - (.1833 × .4)) = .07914.
e. Verify the results in the solutions to f) and g) above by preparing the pro forma income statement and balance sheet for McGraw, using the 7.914% sustainable growth rate.
The pro forma statements for McGraw, assuming a growth rate of 7.914%, are as follows:
T. MC GRAW CORPORATION
Pro Forma Income Statement
Sales
$10,791.40
– Costs
8,093.55
Taxable income
$ 2,697.85
– Taxes (34%)
917.27
Net income
$ 1,780.58
Retained earnings
$ 712.23
Dividends
$ 1,068.35
Pro Forma Balance Sheet
Current assets
$ 5,395.70
Total debt
$ 6,000.00
Fixed assets
10,791.40
Owner's equity
9,712.00
Total
$16,187.10
Total
$15,712.23
External funds needed
$ 474.87
Since the external financing is all debt, the debt/equity ratio is ($46,474.87/$9,712.23) = 66.667%; the debt/equity ratio is unchanged from the calculation in the solution shown in Part A.
PM
=
$1,650/$10,000 = 16.5%
R
=
$660/$1,650 = 40%
ROA
=
$1,650/$15,000 = 11%
ROE
=
$1,650/$9,000 = 18.333%
D/E
=
$6,000/$9,000 = 66.667%
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