Question

Several factors affect a firm’s need for external funds. Evaluate the effect of each following factor and place a check next to each factor that is likely to increase a firm’s need for external capital—that is, its AFN (additional funds needed). Check all that apply. The firm increases its dividend payout ratio. The firm’s inventory turnover decreases, with no effect on the sales forecast. The firm previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. Dividends to common shareholders are paid out of after-tax earnings. Do these payouts affect a firm’s AFN? No, dividends do not affect a firm’s AFN, because they are paid out of after-tax earnings. Yes, dividends still affect a firm’s AFN even though they are paid out of after-tax earnings.

Answer 1

Answer:

1.

• The firm increases its dividend payout ratio.

This will increase the need for external funds because with more funds going towards dividends, there will be less funds available to fund operations. The company will therefore be more probable of being in need of Additional funds.

• The firm’s inventory turnover decreases, with no effect on the sales forecast.

If the firm's inventory turnover increases, it means that the firm is taking longer to sell off inventory. This will mean that the company will have to invest more in working capital to maintain these inventory levels. This will lead to a higher probability of them needing additional funds.

2. Yes, dividends still affect a firm’s AFN even though they are paid out of after-tax earnings.

Even though they are paid after-tax, they still eat into the funds that the business can be able to set aside to fund operations. So when dividends are paid, the need for AFN increases as well.