CHAPTER 4Long-Term Financial Planning and Growth

I. DEFINITIONS

PLANNING HORIZONa 1. The long-range time period, usually the next two to five years, over which the financial

planning process focuses is known as the:a. planning horizon.b. planning strategy.c. planning agenda.d. short-run.e. current financing period.

AGGREGATIONb 2. The process by which smaller investment proposals of each of a firm’s operational

units are added up and treated as one big project is known as:a. separation.b. aggregation.c. conglomeration.d. appropriation.e. striation.

PRO FORMA STATEMENTSd 3. Pro forma financial statements are:

a. statements recapping the performance of a firm for the past five years.b. accounting statements filed with the Securities and Exchange Commission.c. accounting statements filed with the Internal Revenue Service.d. projected accounting statements based on a sales forecast.e. the most-recently compiled accounting statements of a firm.

PLUG VARIABLEe 4. The designated source of external financing required to make a pro forma balance sheet

balance is called the:a. retained earnings account.b. common stock account.c. debt-equity ratio.d. cash flow variable.e. plug variable.

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PERCENTAGE OF SALES APPROACHa 5. The financial planning method in which accounts vary depending on a firm’s predicted

sales level is called the _____ approach.a. percentage of salesb. sales dilutionc. sales reconciliationd. common-sizee. time-trend

DIVIDEND PAYOUT RATIOc 6. The dividend payout ratio is calculated as:

a. net income minus additions to retained earnings.b. cash dividends divided by the change in retained earnings.c. cash dividends divided by net income.d. net income minus cash dividends.e. one plus the retention ratio.

RETENTION RATIOb 7. The retention ratio is calculated as:

a. one plus the dividend payout ratio.b. the additions to retained earnings divided by net income.c. the additions to retained earnings divided by dividends paid.d. net income minus additions to retained earnings.e. net income minus cash dividends.

CAPITAL INTENSITY RATIOd 8. The capital intensity ratio is calculated as:

a. long-term debt multiplied by total assets.b. net fixed assets divided by net income.c. net fixed assets multiplied by total sales.d. total assets divided by total sales.e. total sales divided by total assets.

INTERNAL GROWTH RATEc 9. The internal growth rate of a firm is best described as the:

a. minimum growth rate achievable if the firm does not pay out any cash dividends.b. minimum growth rate achievable if the firm maintains a constant equity multiplier.c. maximum growth rate achievable without external financing of any kind.d. maximum growth rate achievable without using any external equity financing, and

while maintaining a constant debt-equity ratio.e. maximum growth rate achievable without any limits on the level of debt financing.

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SUSTAINABLE GROWTH RATEd 10. The sustainable growth rate of a firm is best described as the:

a. minimum growth rate achievable if the firm does not pay out any cash dividends.b. minimum growth rate achievable if the firm maintains a constant equity multiplier.c. maximum growth rate achievable without external financing of any kind.d. maximum growth rate achievable without using any external equity financing, and

while maintaining a constant debt-equity ratio.e. maximum growth rate achievable without any limits on the level of debt financing.

II. CONCEPTS

FINANCIAL PLANNING ELEMENTSe 11. Which of the following are basic elements of financial planning for a corporation?

I. dividend policyII. net working capital decisionIII. capital budgeting decisionIV. capital structure policya. I and IV onlyb. II and III onlyc. I, III, and IV onlyd. II, III,and IV onlye. I, II, III, and IV

FINANCIAL PLANNINGb 12. Financial planning:

a. is limited to projecting activities of a firm for the next twelve months.b. formulates the way in which financial goals are to be achieved.c. is formulated based primarily on a net income assumption.d. for capital acquisitions is done on a purely segregated basis.e. focuses solely on the assumptions that are most likely to occur.

FINANCIAL PLANNINGd 13. Financial planning:

a. encourages managers to separate their goals from their plans.b. is generally based solely on the best-case scenario.c. generally has been found ineffective.d. helps managers establish priorities.e. prevents firms from encountering surprise events.

PLANNING HORIZONd 14. Managers of the Automotive Warehouse are currently in the process of updating their

financial plans and preparing revised pro forma statements. During this process, the managers should focus primarily on which of the following future time periods?

a. 6 to 12 monthsb. 1 to 3 yearsc. 1 to 6 yearsd. 2 to 5 yearse. 2 to 10 years

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AGGREGATIONb 15. One of the primary benefits of aggregation is gaining an understanding of the:

a. interactions of the net working capital.b. total investment needs of the firm.c. trade-offs between debt and equity.d. trade-offs between the dividend policy and the plowback ratio.e. total asset turnover ratio.

PERCENTAGE OF SALES APPROACHb 16. When utilizing the percentage of sales approach, managers:

I. determine the level of sales required based on the desired profit margin percentage.II. need to identify which expenses are variable and which are fixed.III. need to determine the capital intensity ratio.IV. can ignore any projected dividends.a. I and II onlyb. II and III onlyc. III and IV onlyd I, II, and IV onlye. I, III, and IV only

SALES FORECASTSe 17. Sales forecasts are:

I. frequently based on macroeconomic projections.II. often affected by industry forecasts.III. generally the output from most pro forma statements.IV. generally the basis for projecting future asset requirements.a. I and II onlyb. III and IV onlyc. II and III onlyd. I, II, and III onlye. I, II, and IV only

PRO FORMA STATEMENTSa 18. When constructing a pro forma statement, net working capital generally varies:

a. directly with sales.b. with the level of capacity utilization.c. directly with the growth rate of fixed assets.d. based upon the financial leverage employed.e. as necessary to get the balance sheet to balance.

PRO FORMA STATEMENTSd 19. When fixed assets on a pro forma statement are projected to increase at a rate

equivalent to the projected rate of sales growth, it can be assumed that the firm is:a. projected to grow at the internal rate of growth.b. projected to grow at the sustainable rate of growth.c. creating excess capacity.d. currently operating at full capacity.e. retaining all of its projected net income.

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PRO FORMA STATEMENTSb 20. A firm is currently operating at full capacity. Net working capital, costs, and all assets

vary directly with sales. The firm does not wish to obtain any additional equity financing. The dividend payout ratio is constant at 40 percent. When the firm compiles a pro forma statement, the plug variable is most likely going to be:

a. accounts payable.b. long-term debt.c. fixed assets.d. retained earnings.e. common stock.

PRO FORMA STATEMENTSb 21. The composition of the liability and equity sections of a pro forma statement depend

most heavily on a firm’s:a. net working capital policies.b. financing and dividend policies.c. desired level of liquidity.d. capital budgeting and working capital policies.e. level of capacity utilization and net working capital policy.

PRO FORMA STATEMENTSc 22. You are comparing a current income statement and a pro forma income statement for a

firm. The pro forma statement reflects a 7 percent rate of growth. Both income statements include a common-size statement. The firm is currently operating at 80 percent of their capacity. On the pro forma statement, all costs increase at the same rate as sales. Given this,

a. the net income shown on both statements is identical.b. the tax rate is assumed to increase at the same rate as the sales.c. both common size income statements are identical.d. the projected increase in retained earnings is equal to the current increase in retained

earnings.e. total assets are required to also increase at a rate equal to the rate of sales growth.

PRO FORMA STATEMENTSd 23. Which of the following statements concerning pro forma financials are correct?

I. A pro forma income statement should consider both macroeconomic and industry forecasts.

II. Pro forma statements should consider the dividend policy of the firm.III. A pro forma balance sheet must always maintain the current debt-equity ratio of a firm.IV. A pro forma balance sheet should include consideration of the capacity level of the

firm.a. I and II onlyb. III and IV onlyc. I, III, and IV onlyd. I, II, and IV onlye. I, II, III, and IV

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PRO FORMA STATEMENTSc 24. By compiling pro forma statements, firms can:

a. ensure that their anticipated rate of growth will in fact occur.b. avoid increasing their level of financial leverage while still increasing the growth rate

of the firm.c. see the projected effects of their planned activities.d. determine how to grow at a rate that exceeds their sustainable rate of growth without

increasing their equity financing.e. reduce the daily level of management involvement in the operations of the firm.

PRO FORMA STATEMENTSb 25. To ascertain the amount of total assets required to support a projected level of sales,

you primarily need to know the:a. projected level of capacity utilization.b. capital intensity ratio.c. financial structure policy of the firm.d. rate of internal growth.e. fixed-asset utilization rate.

PLOWBACK RATIOb 26. The plowback ratio:

a. is equal to net income divided by the change in total equity.b. shows the percentage of net income available to the firm for future growth.c. plus the retention ratio must equal 100 percent.d. is equal to the change in retained earnings divided by the dividends paid.e. represents the earnings returned to the shareholders.

RETENTION RATIOe 27. Big Mac’s and Small Dog’s are two firms that are equal in every way except for their

retention ratios. Big Mac’s has a 50 percent retention ratio. Small Dog’s has a 60 percent retention ratio. Given this difference,

a. Small Dog’s profit margin next year will exceed the profit margin of Big Mac’s.b. Small Dog’s dividend payout ratio will exceed that of Big Mac’s.c. Big Mac’s plowback ratio will exceed that of Small Dog’s.d. Big Mac’s has a higher internal rate of growth than does Small Dog’s.e. Small Dog’s has a higher sustainable rate of growth than does Big Mac’s.

CAPITAL INTENSITY RATIOe 28. Which one of the following statements concerning the capital intensity ratio is correct?

a. The capital intensity ratio is equal to sales divided by net fixed assets.b. The lower the capital intensity ratio, the greater the capital intensity level of the firm.c. The capital intensity ratio is equal to one minus the total asset turnover ratio.d. The capital intensity ratio is based on the degree of financial leverage employed by a

firm.e. The capital intensity ratio tells the amount of total assets needed to generate each

dollar of sales.

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CAPITAL INTENSITY RATIOe 29. You are comparing the financial statements of General Motors (an automaker) and

Sears (a department store). Which of the following items should you consider if you

are attempting to compare the future growth prospects of both firms?I. profit marginII. capital intensityIII. dividend policyIV. capital structure policya. I and III onlyb. II and IV onlyc. I, II, and III onlyd. II, III, and IV onlye. I, II, III, and IV

EXTERNAL FINANCING NEEDd 30. Any external financing need is generally covered by:

a. the net income retained by the firm.b. adjusting accounts payable.c. adjusting the projected cash balance.d. adjusting the level of debt or equity.e. the projected operating cash flow.

PERCENTAGE OF SALES APPROACHd 31. Sales can often increase without increasing which one of the following?

a. accounts receivableb. cost of goods soldc. manufacturing labord. fixed assetse. inventory

FULL-CAPACITY SALESd 32. If a firm is at full-capacity sales, it means the firm is at the maximum level of

production possible without increasing:a. net working capital.b. cost of goods sold.c. inventory.d. fixed assets.e. the debt ratio.

INTERNAL GROWTH RATEd 33. The internal growth rate increases when the:

a. retention ratio decreases.b. dividend payout ratio increases.c. net income decreases.d. total assets decrease.e. plowback ratio decreases.

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EXTERNAL FINANCING NEEDe 34. Which of the following are generally expected to increase as the projected growth rate

of a firm increases?I. addition to retained earningsII. external financing needIII. fixed assetsIV. current assetsa. II and IV onlyb. I, II, and IV onlyc. I, III, and IV onlyd. I, II, and III onlye. I, II, III, and IV

SUSTAINABLE GROWTH RATEa 35. The sustainable growth rate will be equivalent to the internal growth rate when:

a. a firm has no debt.b. the growth rate is positive.c. the plowback ratio is positive but less than 1.d. a firm has a debt-equity ratio exactly equal to 1.e. net income is greater than zero.

SUSTAINABLE GROWTH RATEb 36. The sustainable growth rate:

a. assumes there is no external financing of any kind.b. is normally higher than the internal growth rate.c. assumes the debt-equity ratio is variable.d. is based on receiving additional external debt and equity financing.e. assumes that 100 percent of all income is retained by the firm.

SUSTAINABLE GROWTH RATEd 37. If a firm bases its growth projection on the rate of sustainable growth, and shows

positive net income, then the:a. fixed assets will have to increase at the same rate, regardless of the current capacity

level.b. number of common shares outstanding will increase at the same rate of growth.c. debt-equity ratio will have to increase.d. debt-equity ratio will remain constant while retained earnings increase.e. fixed assets, debt-equity ratio, and number of common shares outstanding will all

increase.

SUSTAINABLE GROWTH RATEd 38. Marcie’s Mercantile wants to maintain their current dividend policy, which is a payout

ratio of 40 percent. The firm does not want to increase their equity financing but are willing to maintain their current debt-equity ratio. Given these requirements, the

maximum rate at which Marcie’s can grow is equal to:a. 40 percent of the internal rate of growth.b. 60 percent of the internal rate of growth.c. the internal rate of growth.d. the sustainable rate of growth.e. 60 percent of the sustainable rate of growth.

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DETERMINANTS OF GROWTHc 39. Which of the following statements concerning the sustainable growth rate are correct?

I. A decrease in the profit margin will decrease the sustainable rate of growth.II. Decreasing capital intensity increases the sustainable rate of growth.III. Decreasing the debt-equity ratio also decreases the sustainable rate of growth.IV. Decreasing the dividend payout ratio also decreases the sustainable rate of growth.a. I and II onlyb. III and IV onlyc. I, II, and III onlyd. I, III, and IV onlye. I, II, III, and IV

FINANCIAL PLANNINGb 40. One of the primary advantages of financial planning is that it:

a. concentrates solely on short-term profits.b. reconciles planned activities with company priorities.c. establishes the highest possible growth rate at any cost.d. limits expansion to the maximum achievable internal rate of growth.e. eliminates future surprises and unplanned activities.

FINANCIAL PLANNING MODELSe 41. One of the primary weaknesses of many financial planning models is that they:

a. rely too much on financial relationships and too little on accounting relationships.b. are iterative in nature.c. ignore the goals and objectives of senior management.d. are based solely on best case assumptions.e. ignore the size, risk, and timing of cash flows.

FINANCIAL PLANNING MODELSe 42. Financial planning:

I. is an on-going process.II. must consider the constraints that exist both internally and externally.III. helps a firm establish priorities.IV. reconciles the activities of the various departments within a firm.a. III and IV onlyb. II and III onlyc. I, II, and IV onlyd. II, III, and IV onlye. I, II, III, and IV

FINANCIAL PLANNINGd 43. Financial planning, when properly executed,

a. ignores the normal restraints encountered by a firm.b. ensures that the primary goals of senior management are fully achieved.c. reduces the necessity of daily management oversight of the business operations.d. helps ensure that proper financing is in place to support the desired level of growth.e. eliminates the need to plan more than one year in advance.

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III. PROBLEMS

PRO FORMA STATEMENTSc 44. Baker’s Dozen has current sales of $1,400 and a profit margin of 7 percent. The firm

estimates that sales will increase by 8 percent next year and that all costs will vary in direct relationship to sales. What is the pro forma net income?

a. $90.72b. $98.00c. $105.84d. $107.84e. $119.84

PRO FORMA STATEMENTSb 45. A firm, which is currently operating at full capacity, has sales of $2,000, current assets

of $600, current liabilities of $300, net fixed assets of $1,500, and a 5 percent profit margin. The firm has no long-term debt and does not plan on acquiring any. The firm does not pay any dividends. Sales are expected to increase by 10 percent next year. If all assets, liabilities and costs vary directly with sales, how much additional equity financing is required for next year?

a. $10b. $70c. $170d. $200e. $210

PRO FORMA STATEMENTSc 46. Jose’s Boxed Goods expects sales of $1,800 next year. The profit margin is 6 percent

and the firm has a 40 percent dividend payout ratio. What is the projected increase in retained earnings?

a. $28.80b. $43.20c. $64.80d. $76.20e. $108.00

FULL CAPACITY SALES LEVELd 47. Rosie’s currently has $1,200 in sales and is operating at 72 percent of the firm’s

capacity. What is the full capacity level of sales?a. $864.00b. $1,333.33c. $1,428.00d. $1,666.67e. $1,728.00

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CAPITAL INTENSITY RATIOc 48. Roy and Flo’s Flowers has $1,300 of sales and $1,755 of total assets. The firm is

operating at 80 percent of capacity. What is the capital intensity ratio at full capacity?a. $.59b. $.93c. $1.08d. $1.43e. $1.69

CAPITAL INTENSITY RATIOb 49. Kurt’s Adventures is operating at full capacity with a sales level of $1,200 and fixed

assets of $900. What is the required addition to fixed assets if sales are to increase by 20 percent?

a. $160b. $180c. $240d. $320e. $360

CAPACITY USAGE AND CAPITAL INTENSITY RATIOe 50. Ernie’s Electrical has a capital intensity ratio of 1.20 at full capacity. Currently, total

assets are $2,880 and current sales are $2,300. At what level of capacity is the firm currently operating?

a. 63 percentb. 67 percentc. 69 percentd. 83 percente. 96 percent

FULL CAPACITY SALES AND FIXED ASSETSd 51. A firm has current sales of $940,000 and is operating at 76 percent of its fixed asset

capacity. How fast can the firm grow before any new fixed assets are needed?a. 28.97 percentb. 29.08 percentc. 30.67 percentd. 31.58 percente. 33.33 percent

SUSTAINABLE GROWTH AND DU PONT IDENTITYc 52. The Green Giant has a 5 percent profit margin and a 40 percent dividend payout ratio.

The total asset turnover is 1.40 and the equity multiplier is 1.50. What is the sustainable rate of growth?

a. 6.30 percentb. 6.53 percentc. 6.72 percentd. 6.80 percente. 6.83 percent

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SUSTAINABLE GROWTH AND DEBT-EQUITY RATIOb 53. A firm wants a sustainable growth rate of 2.68 percent while maintaining a 40 percent

dividend payout ratio and a 6 percent profit margin. The firm has a capital intensity ratio of 2. What is the debt-equity ratio that is required to achieve the firm’s desired rate of growth?

a. .42b. .45c. .49d. .52e. .54

SUSTAINABLE GROWTH AND PROFIT MARGINd 54. A firm has a plowback ratio of 80 percent and a sustainable growth rate of 7.759

percent. The capital intensity ratio is 1.2 and the debt-equity ratio is .5. What is the profit margin?

a. 6.6 percentb. 6.8 percentc. 6.9 percentd. 7.2 percente. 7.4 percent

SUSTAINABLE GROWTH AND RETENTION RATIOc 55. A firm wants to maintain a growth rate of 8 percent without incurring any additional

equity financing. The firm maintains a constant debt-equity ratio of .5, a total asset turnover ratio of .83, and a profit margin of 8 percent. What must the retention ratio be?

a. 71.8 percentb. 72.7 percentc. 74.4 percentd. 75.1 percente. 76.3 percent

SUSTAINABLE GROWTH AND OUTSIDE FINANCINGa 56. Guido’s Garden Supplies has sales of $180,000, net income of $14,400, total assets of

$280,000, total equity of $200,000, and paid $5,760 in dividends. The firm maintains a constant dividend payout ratio. The firm is currently operating at full capacity. All costs and assets vary directly with sales. The firm does not want to obtain any additional external equity. At the sustainable rate of growth, how much new total debt must the firm acquire?

a. $3,612b. $4,008c. $6,116d. $10,793e. $12,382

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INTERNAL GROWTH RATEc 57. Neal’s Nails has an 11 percent return on assets and a 30 percent dividend payout ratio.

What is the internal growth rate?a. 7.11 percentb. 7.70 percentc. 8.34 percentd. 8.46 percente. 11.99 percent

INTERNAL GROWTH RATEa 58. Katelyn’s Kites has net income of $240 and total equity of $2,000. The debt-equity

ratio is 1.0 and the plowback ratio is 40 percent. What is the internal growth rate?a. 2.46 percentb. 3.00 percentc. 4.92 percentd. 5.88 percente. 6.00 percent

The following balance sheet and income statement should be used for questions #59 through #65:

Make Me Think, Inc.2005 Income Statement

Net sales $7,500Less: Cost of goods sold 6,415Less: Depreciation 200Earnings before interest and taxes 885Less: Interest paid 25Taxable Income $ 860Less: Taxes 300Net income $ 560 Dividends $252 Addition to retained earnings $308

Make Me Think, Inc.2005 Balance Sheet

2005 2005Cash $1,050 Accounts payable $1,750Accounts rec. 850 Long-term debt 330Inventory 2,100 Common stock 2,500Total $4,000 Retained earnings 1,020Net fixed assets 1,600Total assets $5,600 Total liabilities & equity $5,600

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RETENTION RATIOd 59. Make Me Think, Inc. maintains a constant dividend payout ratio. What is their

retention ratio?a. 40 percentb. 45 percentc. 50 percentd. 55 percentd. 60 percent

INTERNAL GROWTH RATEb 60. Make Me Think, Inc. does not want to incur any additional external financing. The

dividend payout ratio is constant. What is their maximum rate of growth?a. 4.71 percentb. 5.82 percentc. 6.34 percentd. 9.48 percente. 11.11 percent

SUSTAINABLE GROWTH RATEd 61. If Make Me Think, Inc. decides to maintain a constant debt-equity ratio, what rate of

growth can they maintain?a. 8.20 percentb. 8.75 percentc. 9.13 percentd. 9.59 percente. 9.84 percent

EXTERNAL FINANCING NEED AT MAXIMUM CAPACITYb 62. Make Me Think, Inc. 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 10 percent?

a. $30.30b. $46.20c. $329.00d. $354.20e. $363.00

EXTERNAL FINANCING NEED AT LESS THAN MAXIMUM CAPACITYa 63. Make Me Think, Inc. is currently operating at 80 percent of capacity. All costs and net

working capital vary directly with sales. The tax rate, the profit margin, 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 10 percent?

a. -$113.80b. $194.20c. $225.00d. $329.00e. $354.20

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INCREASE IN RETAINED EARNINGSd 64. Assume that the profit margin and the dividend payout ratio of Make Me Think, Inc.

are constant. If sales increase by 12 percent, what is the projected addition to retained earnings?

a. $36.96b. $37.20c. $136.96d. $344.96e. $369.60

INCREASE IN NET FIXED ASSETSa 65. Assume that Make Me Think, Inc. is currently operating at 85 percent of capacity and

that sales are projected to increase to $9,600. What is the projected addition to fixed assets?

a. $141b. $367c. $448d. $660e. $776

The following balance sheet and income statement should be used for questions #66 through #74:

KNF, Inc.2005 Income Statement

Net sales $10,300Less: Cost of goods sold 7,400Less: Depreciation 1,500Earnings before interest and taxes 1,400Less: Interest paid 340Taxable Income $ 1,060Less: Taxes 371Net income $ 689 Dividends $310.05 Addition to retained earnings $378.95

KNF, Inc.2005 Balance Sheet

2005 2005Cash $ 840 Accounts payable $ 1,010Accounts rec. 750 Long-term debt 4,800Inventory 930 Common stock 5,300Total $ 2,520 Retained earnings 3,770Net fixed assets 12,360Total assets $14,880 Total liabilities & equity $14,880

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PERCENTAGE OF SALESc 66. All costs and net working capital vary directly with sales. Sales are projected to

increase by 7 percent. What is the projected increase in accounts payable?a. $7.50b. $15.00c. $70.70d. $77.70e. $105.70

RETAINED EARNINGSd 67. The profit margin, the debt-equity ratio, and the dividend payout ratio are constant.

Sales are expected to increase by $875.50 next year. What is the projected addition to retained earnings for next year?

a. $321.55b. $366.35c. $389.09d. $411.16e. $747.57

TOTAL ASSETSe 68. Assume that KNF, Inc. is operating at full capacity. Also assume that all costs, net

working capital, and fixed assets vary directly with sales. The debt-equity ratio and the dividend payout ratio are constant. What is the projected increase in total assets if sales are projected to increase by 12 percent?

a. $302.40b. $1,116.08c. $1,483.20d. $1,503.33e. $1,785.60

FULL CAPACITY SALES AND FIXED ASSETSa 69. Assume that KNF, Inc. is operating at 80 percent of capacity. All costs and net

working capital vary directly with sales. What is the amount of total fixed assets required if sales are projected to increase by 25 percent?

a. $12,360b. $14,880c. $15,450d. $17,300e. $18,600

EXTERNAL FINANCING NEEDa 70. Assume that KNF, Inc. is operating at full capacity. Also assume that assets and costs

vary directly with sales but liabilities do not. The dividend payout ratio is constant. What is the external financing need if sales increase by 8 percent?

a. $781.13b. $808.08c. $1,160.08d. $1,696.80e. $1,713.09

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ADDITION TO RETAINED EARNINGSc 71. KNF, Inc. is projecting sales to increase by 5 percent next year and the profit margin to

remain constant. The firm wants to increase the dividend payout ratio by 10 percent. What is the amount of the projected addition to retained earnings for next year?

a. $358.11b. $341.06c. $365.34d. $390.67e. $437.69

INTERNAL GROWTH RATEb 72. What is the internal growth rate of KNF, Inc. if the dividend payout ratio remains

constant?a. 2.55 percentb. 2.61 percentc. 3.33 percentd. 3.42 percente. 4.18 percent

INTERNAL GROWTH RATE AND RETAINED EARNINGSb 73. What is the projected addition to retained earnings if KNF, Inc. grows at the internal

rate of growth and both the profit margin and the dividend payout ratio remain constant?

a. $386.61b. $388.85c. $391.91d. $393.03e. $394.79

SUSTAINABLE GROWTH RATEa 74. Assume that all costs, assets, and current liabilities of KNF, Inc. increase directly with

sales. Also assume that the tax rate and the dividend payout ratio are constant. The firm is currently operating at full capacity. What is the external financing need if sales increase by 10 percent?

a. $970.15b. $1,349.10c. $1,387.00d. $1,404.10e. $1,424.90

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The following balance sheet and income statement should be used for questions #75 through #80:

Re Do It, Inc.2005 Income Statement

Net sales $4,900Less: Cost of goods sold 3,265Less: Depreciation 825Earnings before interest and taxes 810Less: Interest paid 130Taxable Income $ 680Less: Taxes 238Net income $ 442 Dividends $110.50 Addition to retained earnings $331.50

Re Do It, Inc.2005 Balance Sheet

2005 2005Cash $ 30 Accounts payable $1,080Accounts rec. 390 Long-term debt 1,740Inventory 880 Common stock 2,100Total $1,300 Retained earnings 2,980Net fixed assets 6,600Total assets $7,900 Total liabilities & equity $7,900

FULL CAPACITY SALESd 75. Re Do It, Inc. is currently operating at 78 percent of capacity. What is the full-capacity

level of sales?a. $3,822b. $5,568c. $5,978d. $6,282e. $14,062

CAPITAL INTENSITYc 76. Re Do It, Inc. is currently operating at 84 percent of capacity. What is the capital

intensity ratio at full capacity?a. $1.13b. $1.21c. $1.35d. $1.44e. $1.60

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ADDITION TO RETAINED EARNINGSd 77. Re Do It, Inc. is currently operating at 90 percent of capacity. The profit margin and

the dividend payout ratio are projected to remain constant. Sales are projected to increase by 5 percent next year. What is the projected addition to retained earnings for next year?

a. $116.03b. $315.71c. $328.04d. $348.08e. $464.10

EXTERNAL FINANCING NEEDe 78. Re Do It, Inc. is currently operating at full capacity. The profit margin and the

dividend payout ratio are constant. Net working capital and fixed assets vary directly with sales. Sales are projected to increase by 6 percent. What is the external financing need?

a. $46.08b. $47.78c. $49.03d. $54.67e. $57.81

INTERNAL GROWTH RATEd 79. Re Do It, Inc. maintains a constant dividend payout ratio. The firm is currently

operating at full capacity. What is the maximum rate at which the firm can grow without acquiring any additional external financing?

a. 4.14 percentb. 4.18 percentc. 4.20 percentd. 4.38 percente. 4.41 percent

CAPACITY UTILIZATION AND INCREASE IN FIXED ASSETSa 80. Re Do It, Inc. is currently operating at 90 percent of capacity. What is the required

increase in fixed assets if sales are projected to increase by 15 percent?a. $231b. $309c. $458d. $891e. $990

IV. ESSAYS

81. Why is it important for managers to understand the importance of both the internal and the sustainable rates of growth?

One reason that causes firms to go out of business is the lack of external funding to support the growth of the firm. Understanding the implications of both the internal and sustainable growth rates can help management know when to limit firm growth such that the growth does not exceed the availability of the necessary financing to fund that growth.

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FINANCIAL PLANNING82. The textbook states that “conventional business wisdom holds that financial plans don’t

work, but financial planning does.” If financial plans don’t work, what is achieved by going through the process of financial planning?

An underlying theme of the chapter is that, while no one can predict future events, the act of planning for various contingencies forces decision-makers to consider what might happen. It also helps managers see the interactions between their investment and financing decisions and the implications of those decisions on other aspects of a firm’s performance. Much of the benefit of financial planning derives from the aggregative and integrative nature of the planning process.

SALES GROWTH83. It is stated in the text that the planner’s assumptions about future sales growth serves as the

“driver” for the financial plan. What factors and/or types of decisions determine how much sales growth the firm can accommodate?

This is an open-ended question which really gets to the heart of the financial planning process; i.e., the management of growth. Some instructors may wish to emphasize in their lectures that (to paraphrase Higgins) a firm can “grow itself out of business”. In other words, rapid, unexpected sales increases can result in poor capital budgeting, financing, or working capital decisions. By understanding what factors contribute to the firm’s internal and sustainable growth rates, students can better understand the nature of the decisions necessary to accommodate growth.

SUSTAINABLE GROWTH84. State the assumptions that underlie the sustainable growth rate and interpret what the

sustainable growth rate means.

The usual assumptions are: Costs and assets increase proportionately with sales, the dividend payout ratio is fixed (or is given), the current debt-equity ratio is optimal, and no new equity sales are possible. The sustainable growth rate is the maximum rate at which sales can increase with the restriction that no new equity sales are possible and long-term debt increases only in an amount that keeps the debt-equity ratio fixed.

NEGATIVE EFN85. Suppose a firm calculates its external funding needs and finds that it is negative. What are

the firm’s options in this case?

With a negative external financing need, the firm has a surplus of funds that it can use to reduce current liabilities, reduce long-term debt, buy back common stock, or increase dividends. If acceptable opportunities exist, firms might also use the extra funds to add assets.

CHAPTER 4

INTERPRETING GROWTH86. If a firm has the option of growing at a 10 percent rate versus a 7 percent rate, should the

firm always opt for the higher rate of growth? Explain why or why not.

No. The best rate of growth for a firm is determined by several factors. One of the key factors is the availability of funding to support the desired level of growth. In many cases, the lower rate of growth may, in fact, be the best option for the firm.