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dividend payment is effectively fixed

1 The firm cannot issue debt, and its dividend payment is effectively fixed, which limits retained earnings to $40. Therefore, the balancing item must be new equity issues. The firm must raise $200 Ј $40 = $160 through equity sales in order to finance its plans for $200 in asset acquisitions.

2 a. The total amount of external financing is unchanged, since the dividend payout is unchanged. The $100,000 increase in total assets will now be financed by a mixture of debt and equity. If the debt-equity ratio is to remain at 2вБД3, the firm will need to increase equity by $60,000 and debt by $40,000. Since retained earnings already increase shareholders` equity by $36,000, the firm needs to issue an additional $24,000 of new equity and $40,000 of debt.

b. If dividends are frozen at $64,000 instead of increasing to $72,000 as envisioned in Table 1.15, then the required external funds fall by $8,000 to $56,000.

3 a. The company currently runs at 80 percent of capacity given the current level of fixed assets. Sales can increase until the company is at 100 percent of capacity; therefore, sales can increase to $60 million (100/80) = $75 million.

b. If sales were to increase by 50 percent to $90 million, new fixed assets would need to be added. The ratio of assets to sales when the company is operating at 100 percent of capacity (from part a) is $50 million/$75 million = 2/3. Therefore, to support sales of $90 million, the company needs at least $90 million 2/3 = $60 million of fixed assets. This calls for a $10 million investment in additional fixed assets.

4 a. This question is answered by the planning model. Given assumptions for asset growth, the model will show the need for external financing, and this value can be compared to the firm`s plans for such financing.

b. Such a relationship may be assumed and built into the model. However, the model does not help to determine whether it is a reasonable assumption.

c. Financial models do not shed light on the best capital structure. They can tell us only whether contemplated financing decisions are consistent with asset growth.

5 a. If the payout ratio were reduced to 25 percent, the maximum growth rate assuming no external financing would be .75 16 percent .6 = 7.2 percent.

b. If the firm also can issue enough debt to maintain its equity-to-asset ratio unchanged, the sustainable growth rate will be .75 16 percent = 12 percent.