Question

The firm projected its proforma of financial statements using AFN method and finds that next year its AFN is $2 million. Its total asset this year is $40 million and its net sales this year is $50 million. The CFO has decided to finance its entire projected AFN through issuing common stock. What would you expect to happen in next year’s financial ratio based on AFN method if we expect its net income remains constant?

Answer 1

Its earnings per share will decrease.

Its return on equity will go down.

Its equity multiplier will go down.

Step-by-step explanation:

Since net income remains the same, earnings per share will decrease. This happens because there will be more stocks outstanding (the denominator in the EPS formula), so the result will be lower.

Return on equity will also decrease, since net income will remain the same while equity increases (same logic as EPS).

Unless this company is 100% financed through equity, it will have some debt (liabilities). The equity multiplier = total assets / total equity. E.g. total assets increase from $20 to $22 million, and total equity increases from $30 to $32 million.

Original equity multiplier = $40 / $30 = 1.333

Equity multiplier after issuing more stocks = $42 / $32 = 1.3125

C. Its equity multiplier will go down.

D. Its current ratio will go down.

E. Its quick ratio will go down.