Question

Upton Computers makes bulk purchases of small computers, stocks them in conveniently located warehouses, ships them to its chain of retail stores, and has a staff to advise customers and help them set up their new computers. Upton's balance sheet as of December 31, 2019, is shown here (millions of dollars):

Cash $ 3.5
Receivables 26.0
Inventories 58.0
Total current assets $ 87.5
Net fixed assets 35.0
Total assets $122.5
Accounts payable $ 9.0
Notes payable 18.0
Line of credit 0
Accruals 8.5
Total current liabilities $ 35.5
Mortgage loan 6.0
Common stock 15.0
Retained earnings 66.0
Total liabilities and equity $122.5
Sales for 2019 were $350 million, and net income for the year was $10.5 million, so the firm's profit margin was 3.0%. Upton paid dividends of $4.2 million to common stockholders, so its payout ratio was 40%. Its tax rate was 25%, and it operated at full capacity. Assume that all assets/sales ratios, (spontaneous liabilities)/sales ratios, the profit margin, and the payout ratio remain constant in 2020.
(a) If sales are projected to increase by $70 million, or 20%, during 2020, use the AFN equation to determine Upton's projected external capital requirements.
(b) Using the AFN equation, determine Upton's self-supporting growth rate. That is, what is the maximum growth rate the firm can achieve without having to employ nonspontaneous external funds?
(c) Use the forecasted financial statement method to forecast Upton's balance sheet for December 31, 2020. Assume that all additional external capital is raised as a line of credit at the end of the year. (Because the debt is added at the end of the year, there will be no additional interest expense due to the new debt.) Assume Upton's profit margin and dividend payout ratio will be the same in 2020 as they were in 2019. What is the amount of the line of credit reported on the 2020 forecasted balance sheets? (Hint: You don't need to forecast the income statements because the line of credit is taken out on the last day of the year and you are given the projected sales, profit margin, and dividend payout ratio; these figures allow you to calculate the 2020 addition to retained earnings for the balance sheet without actually constructing a full income statement.)

Answer 1

Using the Additional Funds Needed (AFN) formula, we can calculate the external capital requirements for Upton Computers if sales were to increase by $70 million and determine their self-supporting growth rate. Additionally, we can forecast the balance sheet by assuming all new external capital is raised through a line of credit.

Step-by-step explanation:

The question asked requires an analysis of Upton Computers' balance sheet to determine the external capital requirements as sales are projected to increase. When a firm, such as Upton Computers, anticipates an increase in sales, it should consider how to finance its additional assets. To analyze Upton's situation, we would apply the Additional Funds Needed (AFN) formula, which is derived from the company's financial statements.

To calculate the AFN, we use the formula: AFN = (A*/S0)ΔS - (L*/S0)ΔS - MS1RR(1 - d), where A* represents the required assets at full capacity, S0 is the current sales level, ΔS is the change in sales, L* are the spontaneous liabilities, MS1 is the profit margin on sales, RR is the retention ratio, and d is the dividend payout ratio.

After applying the AFN formula and given the constant ratios, we can determine how much external financing is required if sales were to increase by $70 million, and the self-supporting growth rate, which is the growth rate Upton Computers can sustain without external financing. Remember that to forecast the balance sheet, we assume that all additional external capital is reflected as a line of credit, which affects the company's liabilities and equity for the year 2020.