Fundamentals of Financial Management (Concise 6th Edition)

514 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management

16-3 THE AFN EQUATION

We saw in Chapter 3 that in 2008, Allied had assets of $2,000 million and sales of

$3,000 million. Thus, it required $2,000/$3,000 " $0.6667 of assets to generate each

dollar of sales. Moreover, the company plans to increase sales by 10%, or $300 mil-

lion, in 2009:

Increase in Sales! "Sales! 0.10($3,000 million)! $300 million

Assuming the assets-to-sales ratio remains constant, Allied will need an additional

$200 million of assets to support the $300 million increase in sales:

Required increase in assets! 0.6667("Sales)! 0.6667($300)! $200 million

Note that if growth is low (say, 0%), #Sales will be zero and there will be no

required increase in assets. On the other hand, if sales grow very rapidly, the

requirement for additional assets will be large. Thus, the increase in assets is fun-

damentally dependent on the growth rate in sales.

Naturally, if assets are to grow by $200 million, liabilities and equity must also

grow by the same amount—the balance sheet must balance. But where will this

capital come from? Here are a! rm’s primary capital sources:

1. Spontaneous Increases in Accounts Payable and Accruals. Allied must make addi-
   tional purchases to increase its inventories, and it must hire more workers. Its
   purchases will automatically lead to additional accounts payable, which amount
   to “loans” from its suppliers. Also, hiring more workers will automatically lead
   to higher accrued wages, which amount to short-term “loans” from its workers.
   Hence, some of the required $200 million will come spontaneously from suppliers
   and workers—this is called spontaneously generated funds. Also, assuming
   pro! t margins are maintained, higher sales will mean higher pro! ts and thus
   higher taxes and accrued taxes. So “spontaneous” increases in payables, accrued
   wages, and accrued taxes will take care of part of the required $200 million.


2. Addition to Retained Earnings. Assuming Allied has positive earnings and does
   not pay out all of those earnings as dividends, its retained earnings will grow.
   The addition to retained earnings depends on the! rm’s pro! t margin and its
   retention ratio, which is the proportion of net income that is reinvested in the
   ! rm. This addition to retained earnings will help! nance growth.


3. AFN: Additional Funds Needed. It is possible that spontaneous funds and addi-
   tional retained earnings will offset the forecasted increase in assets. Normally,
   though, that situation does not occur—normally, there is a shortfall, called Addi-
   tional Funds Needed (AFN), which has to be made up by additional borrowing
   and/or the sale of new stock. Note, though, that if a company is growing very
   slowly and thus not increasing assets very much, its spontaneous funds plus its
   addition to retained earnings may be larger than the required increase in assets. In
   that case, the AFN is negative, indicating that a surplus of capital is forecasted.
   We can combine these concepts to develop Equation 16-1, the AFN equation. AFN
   is the total amount of new interest-bearing debt and preferred and common stock
   the! rm must issue to support its planned growth.^6

Spontaneously

Generated Funds

Funds that arise out of

normal business

operations from its

suppliers, employees, and

the government (such as

accounts payable and

accrued wages and taxes)

that reduce the firm’s need

for external financing.

Spontaneously

Generated Funds

Funds that arise out of

normal business

operations from its

suppliers, employees, and

the government (such as

accounts payable and

accrued wages and taxes)

that reduce the firm’s need

for external financing.

Retention Ratio

The proportion of net

income that is reinvested

in the firm and is

calculated as 1 minus the

dividend payout ratio.

Retention Ratio

The proportion of net

income that is reinvested

in the firm and is

calculated as 1 minus the

dividend payout ratio.

Additional Funds

Needed (AFN)

The amount of external

capital (interest-bearing

debt and preferred and

common stock) needed to

acquire the needed assets.

Additional Funds

Needed (AFN)

The amount of external

capital (interest-bearing

debt and preferred and

common stock) needed to

acquire the needed assets.

AFN Equation

An equation that shows

the relationship of external

funds needed by a firm to

its projected increase in

assets, the spontaneous

increase in liabilities, and

its increase in retained

earnings.

AFN Equation

An equation that shows

the relationship of external

funds needed by a firm to

its projected increase in

assets, the spontaneous

increase in liabilities, and

its increase in retained

earnings.

(^6) The term additional funds needed was developed to show how much additional capital a! rm needs to support its
planned growth. However, as we see later, a! rm may be able to grow without any additional outside capital. In fact,
the! rm may even generate excess capital that can be used to retire debt, repurchase stock, and raise the dividend.
In this case, the calculated AFN will be negative. Also, in this chapter, we do quite a few calculations and generally
round when we show results. This may lead to minor “rounding di" erences,” which you should disregard.