12-6d Calculating Additional Funds Needed (AFN) If we start with the required new assets and then subtract both spontaneous funds and additions to retained earnings, we are left with the additional funds needed, or AFN. The AFN must come from external sources; hence it is sometimes called EFN. The typical sources of external funds are bank loans new long-term bonds, new preferred stock, and newly issued common stock. The mix of the external funds used should be consistent with the firm's financial policies, especially its target debt ratio. 12-6e Using MicroDrive's Data to Implement the AFN Equation Method Equation 12-1 summarizes the logic underlying the AFN equation method. Figure 12-7 defines the notation in Equation 12-1 and applies identify Micro Drive's AFN. The additional funds needed (AFN) equation is: Required Increase in Increase in increase spontaneous - retained in assets liabilities earnings (A/S, AS - (L/S.AS Additional funds needed AFN (12-1) SzxM x (1 - Payout (1- Ratio We see from Part B of Figure 12-7 that for sales to increase by $500 million, MicroDrive must increase assets by $355 million. Therefore, liabilities and capital must also increase by $355 million. Of this total, $50 million will come from spontaneous liabilities, and another $187 million will come from new retained eamings. The remaining $118 million must be raised from external sources-probably some combination of short- term bank loans, long-term bondspreferred stock, and common stock. Notice that the AFN from this model is very close to the surplus financing required in the Status Quo model for the projected financial statements because both methods assume that the operating ratios for MicroDrive will not change. FIGURE 12-7 Additional Funds Needed (AFN) (Millions of Dollars) G 3995 397 Part A. Inputs and Definitions 398|S: Most recent year's sales = $5,000 Forecasted growth rate in sales = 10.00% 400 S Next year's sales: S,* (1 + 8) - $5,500 401 go Change in sales = 5, -Sn = AS = $500 402 A,*: Most recent year's operating assets = $3,550 403 A.* / So Required assets per dollar of sales - 71.00% 404 L : Most recent year's spontaneous liabilities i.e., payables + accruals = $500 405 Lo* /S: Spontaneous liabilities per dollar of sales = 10.00% 406 Profit margin (M): Most recent profit margin = net income/sales = 4.40% 407 Payout ratio (POR): Most recent year's dividends / net income = % of income paid out = 22.73% 408 Part B. Additional Funds Needed (AFN) to Support Growth 409 410 AFN = Required Increase in Increase in Spon. Liab. Addition to Retained 411 (4.*/S.)As (10*/S. AS S,*M*(1 - POR) 412 413 (A,*/s.) (ES) (12"/3.)(es) (1+g), *M*(1-POR) 414 415 (0.710)(5500) (0.10)($500) $5,500(0.044)(1 -0.2273) 416 $355 $50.00 $187.00 417 AFN = $118.00 i i 12-6f Key Factors in the AFN Equation The AFN equation shows that extemal financing requirements depend on five key factors. 1. Sales growth (g). Rapidly growing companies require large increases in assets and a corresponding large amount of external financing, other things held constant 2. Capital intensity (A,*/80). The amount of assets required per dollar of sales, A,*/S, is the capital intensity ratio, which has a major effect on capital requirements. Companies with relatively high assets-to-sales ratios require a relatively large number of new assets for any given increase in sales; hence they have a greater need for extemal financing. If a firm can find a way to lower this ratio-for instance, by adopting a just-in- time inventory system, by going to two shifts in its manufacturing plants, or by outsourcing rather than manufacturing parts—then it can achieve a given level of growth with fewer assets and thus less new external capital. 3. Spontaneous liabilities-to-sales ratio (L,*/S.). If a company can increase its spontaneously generated liabilities, this will reduce its need for extemal financing. One way of raising this ratio is by paying suppliers in, say, 20 days rather than 10 days. Such a change may be possible but, as we shall see in Chapter 16, it would probably have serious adverse consequences. 4. Profit margin (M = Net Income/Sales). The higher the profit margin, the more net income is available to support increases in assets—and hence the less the need for extemal financing. A firms' profit margin is normally as high as management can get it, but sometimes a change in operations can boost the sales price or reduce costs, thus raising the margin further. If so, this will permit a faster growth rate with less extemal capital. 5. Payout ratio (POR = DPS/EPS). The less of its income a company distributes as dividends, the larger its addition to retained earnings—hence the less its need for extemal capital. Companies typically like to keep their dividends stable or to increase them at a steady rate-stockholders like stable, dependable dividends, so such a dividend policy will generally lower the cost of equity and thus maximize the stock price. So even though reducing the dividend is one way a company can reduce its need for external capital, companies generally resort to this method only if they are under financial duress. 12-6g The Self-Supporting Growth Rate One interesting question is: "What is the maximum growth rate the firm could achieve if it had no access to external capital?" This rate is called the self-supporting growth rate, and it can be found as the value of g that, when used in the AFN equation, results in an AFN of zero. We first replace AS in the AFN equation with gS, and Swith (1+g)S, so that the only unknown is g we then solve for g to obtain the following equation for the self- supporting growth rate: Self-supporting & M(1 - POR) (Sa) Ag * - L* - M(1 - POR) (So) (12-2) urce al Kills on Web site for The definitions of the terms used in this equation are shown in Figure 12-7. If the fim has any positive earnings and pays out less than 100% in dividends, then it will have some additions to retained earnings, and those additions could be combined with spontaneous funds to enable the company to grow at some rate without having to raise external capital. As explained in the chapter's Excel Tool Kit, this value can be found either algebraically or with Excel's Goal Seek function. For MicroDrive, the self-supporting growth rate is 5.9%; this means it could grow at that rate even if capital markets dried up completely, with everything else held constant.
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