Question

Use the below information to answer the following question.

Income Statement
For the Year
Sales $28,400
Cost of goods sold 21,200
Depreciation 2,700

Earnings before interest and taxes $ 4,500
Interest paid 850

Taxable income $ 3,650
Taxes 1,400

Net income $ 2,250

Dividends $900

Balance Sheet
End-of-Year
Cash $ 550
Accounts receivable 2,450
Inventory 4,700

Total current assets $ 7,700
Net fixed assets 16,900

Total assets $24,600

Accounts payable $ 2,700
Long-term debt 9,800
Common stock ($1 par value) 8,000
Retained earnings 4,100

Total Liab. & Equity $24,600


This firm is currently operating at maximum capacity. All costs, assets, and current liabilities vary directly with sales. The tax rate and the dividend payout ratio will remain constant. How much additional debt is required if no new equity is raised and sales are projected to increase by 5 percent?

Answer 1

To calculate the additional debt needed by a company with a projected sales increase of 5%, we must factor in the impacts on total assets and retained earnings, given no new equity is issued, and then determine the shortfall to be covered by new debt.

Step-by-step explanation:

The question concerns the field of corporate finance and involves calculating the additional debt required by a company to support a sales increase, given its current financial statements and assuming no new equity is raised. To solve this, we project increased sales by 5%, recalculate the affected financial statement items, determine the increase in total assets needed to support the new sales level, and then calculate the additional debt required given the dividend payout and retained earnings.

Current total assets are $24,600 with sales of $28,400. With a 5% sales increase, new sales are expected to be $28,400 x 1.05 = $29,820. Assuming all costs and current assets vary directly with sales, the increase in total assets needed is 5% of $24,600 which is $1,230. Since no new equity is raised, the increase in assets must be supported by additional debt and retained earnings. However, the increase in retained earnings would be tied to the net income after paying out dividends. Assuming the same dividend payout ratio, the additional debt can be calculated by subtracting the change in retained earnings due to the net income increase from the additional total assets required.