Question

Most assets can be increased as a percentage of sales. For instance, cash can be increased by any amount However, fixed assets must be increased in specific amounts because it is impossible, as a practical matter to buy part of a new plant or machine. In this case, a com pany has a "staircase" or "lumpy" fixed cost structure. Assume S&S Air is currently producing at 100 percent capacity. As a result, to increase production. the company must set up an entirely new line at a cost of $5.000.000. Calculate the new EFN with this assump- tion. What does this imply about capacity utilization for the company next year?

Answer 1

Assuming that to increase production, the company must set up an entirely new line at a cost of $5,000,000.

Then we still have

On the assets side, current assets still increase spontaneously with sales, but fixed assets increase by a fixed amount of $5,000,000.

Hence, assuming the debt level remains the same, the external financing need is the difference between projected total assets and projected total liabilities and equity.

Therefore, if the company’s sales increase at 12 percent, it has external financing need of $3,796,672.

Currently, the sales to fixed assets ratio is

In projection, the sales to fixed assets ratio is

Since we assume the company is operating at full capacity now, the full capacity sales to fixed assets ratio should be 2.375.

Hence, we have

Therefore, this implies that the company would be operating at 85 percent capacity next year.