Cambridge Prep Shops, a national clothing chain, had sales of $200 million last

Question

Cambridge Prep Shops, a national clothing chain, had sales of $200 million last year. The business has a steady net profit margin of 12 percent and a dividend payout ratio of 40 percent. The balance sheet for the end of last year is shown below.

Balance Sheet End of Year (in $ millions)

Assets                                                                                                               Liabilities and Stockholder's Equity

Cash                                     $10                                                                       Accounts payable                                              $15

Accounts receivable             $15                                                                       Accrued expenses                                              $5

Inventory                               $50                                                                       Other payables                                                   $40

Plant and equipment             $75                                                                       Common stock                                                    $30

                                                                                                                           Retained earnings                                               $60

Total assets                          $150                                                                      Total liabilities and stockholder's equity              $150

Cambridge's marketing staff tells the president that in this coming year there will be a large increase in the demand for tweed sport coats and various shoes. A sales increase of 15 percent is forecast for the Prep Shop.

All balance sheet items are expected to maintain the same percent-of-sales relationships as last year (this included fixed assets as the firm is at full capacity), except for common stock and retained earnings. No change is scheduled in the number of common stock shares outstanding, and retained earnings will change as dictated by the profits and dividend policy of the firm. (Remember the net profit margin is 12 percent.)

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a. Will external financing be required for the Prep Shop during the coming year?

b. What would be the need for external financing if the net profit margin went up to 14 percent and the dividend payout ratio was increased to 70 percent? Explain.

Explanation / Answer

a.

Forecasted change in sale = 15%Total assets = $150 millions

Total assets = $150 millions

Current liabilities = $15 + $5 + $40 = $60 million

Forecasted sales = $200 million * 1.15 = $230 million

Profit margin ratio = 12%

Forecasted profit = $230 million * 12% = $27.60 million

Retention ratio = 1 - Dividend payout ratio = 1 - 0.40 = 0.60

Rtained earnings = $27.60 million * 0.60 = $16.56 million

External financing required = Change in total assets - Change in current liabilities - Retained earnings = ($150 million *15%) - ($60 million * 15%) - $16.56 million = -$3.06 million

Hence no external financing is rqquired.

b.

Retained earnings = $230 million * 14% * (1 - 0.70) = $9.66 million

External financing required = Change in total assets - Change in current liabilities - Retained earnings = ($150 million *15%) - ($60 million * 15%) - $9.66 million = $3.84 million

$3.84 million of external financing shall be needed.

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