Fllama Company is planning its sources of financing for a substantial investment of £30 million next year. The assumptions for Fllama’s plan are the following:
- Investments of £5 million in receivables and £5 million in inventory. Fixed capital investments of £20 million, including £5 million to replace depreciated equipment and £15 million of net new investments. Total investments will be £30 million.
- Net income of £10 million and depreciation charges of £5 million. Dividend payments will be £4 million.
- Short-term financing from accounts payable of £3 million is expected. The company will use receivables as collateral for another £3 million loan. The company will also issue a £4 million short-term note to a commercial bank.
- Any additional external financing needed can be raised from an increase in long-term bonds. If additional financing is not needed, any excess funds will be used to repurchase common shares.
Part A: Describe how Fllama would determine its financing needs.
Part B: How much, if any, does Fllama need to issue in long-term bonds?
- Fllama does not need to issue any bonds.
- Fllama will need to issue £4 million of bonds.
- Fllama will need to issue £9 million of bonds.
Answer:
- Part A: Fllama should begin by considering its various sources of net cash to determine whether its net cash is sufficient to meet its investment needs. The facts state that the company will generate net income and will also have depreciation charges and make dividend payments. Because depreciation is a non-cash expense, it should be added to net income as a source of cash. Dividends, however, are paid from net income, are a use of cash, and reduce the net cash available for funding. Other sources of cash include the amounts generated from accounts payable, accounts receivable, and the short-term note from the bank.
- Part B: C is correct. Fllama must issue £9 million of bonds.
| Source | Amount (£) |
|---|---|
| Internal Financing | |
| Operating cash flow (Net income + depreciation − dividends) | 11,000,000 |
| Accounts payable | 3,000,000 |
| Short-Term Intermediary Financing | |
| Bank loan against receivables | 3,000,000 |
| Short-term note | 4,000,000 |
| Total sources | 21,000,000 |
Because the company requires £30 million of financing and the planned sources total £21 million, Fllama will need to issue £9 million of new bonds.
The curriculum identifies inventories as an internal source of funding, so why do we not include it in the computation of total sources available?
