Northline Components: Growth, Capacity, and External Financing
Northline Components had sales of $18.0 million last year and expects 20% growth. Net income was 6% of sales, and the board has kept the dividend payout at 45%. Current assets were $5.0 million and fixed assets $7.0 million. The plant is currently at 90% of capacity; fixed assets can support $20.0 million of sales before another machine is needed. Accounts payable and accruals, which vary with sales, totaled $2.4 million. Notes payable of $0.6 million, long-term debt of $3.0 million, and equity of $6.0 million complete the balance sheet. The firm has a $1.5 million revolving credit line available. The CFO wants to know whether the growth plan can be funded without a common equity issue and whether the current dividend is prudent. She is also worried that the sales forecast is aggressive and that the plant step-up is lumpy rather than proportional.
1. Compute external financing needed (EFN) for the 20% growth plan, explicitly adjusting fixed assets for the capacity constraint. Show the percentage-of-sales logic.
Read the worked answer
Use percentage-of-sales for current assets and spontaneous liabilities, but treat fixed assets as a step function. Current assets: $5.0M × (21.6/18.0) = $6.00M. Capacity: $18.0M/0.90 = $20.0M at full utilization, so fixed-asset intensity at capacity is $7.0M/$20.0M = 35%. Required fixed assets for $21.6M = 0.35 × 21.6 = $7.56M. Projected assets = $13.56M, an increase of $1.56M. Spontaneous liabilities = $2.4M × 1.20 = $2.88M, an increase of $0.48M. Addition to retained earnings = $21.6M × 6% × (1 − 0.45) = $0.7128M. EFN = $1.56 − $0.48 − $0.7128 = $0.3672M, or about $0.37M. The key judgement is that fixed assets do not rise proportionally; a naive 20% scaling of $7.0M would overstate fixed assets by $0.84M and overstate EFN.
2. Calculate the sustainable growth rate at the current payout and assess whether 20% growth is self-funding. What does the $1.5 million revolver imply for the dividend decision?
Read the worked answer
SGR = (ROE × b)/(1 − ROE × b), where b = 0.55 and ROE = $1.08M/$6.0M = 18%. SGR = (0.18 × 0.55)/(1 − 0.099) = 0.099/0.901 = 10.99%, about 11%. A 20% growth rate is therefore not self-funding; it requires external capital even with a 6% margin. The computed EFN of $0.37M is comfortably inside the $1.5M revolver, so liquidity is not the immediate constraint. However, the revolver is short-term and floating-rate, while the asset being financed-plant capacity-is long-lived. Using the revolver creates refinancing and interest-rate risk. Cutting the payout to 25% would raise retained earnings to $21.6 × 6% × 75% = $0.972M and reduce EFN to about $0.108M, nearly eliminating the need for external funds. The dividend is therefore a real lever, but the board should not cut it solely to avoid a modest, temporary draw if the growth is genuinely profitable.
3. If sales growth comes in at only 12% but the firm still adds the fixed-asset capacity, how does EFN change? What does this imply about committing to the expansion before demand is confirmed?
Read the worked answer
At 12% growth, sales = $20.16M. Current assets = $5.0 × 1.12 = $5.60M. Because $20.16M slightly exceeds the $20.0M capacity, the plant still requires the $7.56M fixed-asset step if management commits to the expansion. Total assets = $13.16M; spontaneous liabilities = $2.688M; retained earnings = $20.16 × 6% × 55% = $0.665M. EFN = ($13.16 − $12.0) − ($2.688 − $2.4) − $0.665 = $0.207M. If management waits and does not add capacity, fixed assets stay at $7.0M and EFN becomes negative-roughly a $0.35M surplus. The judgement is that ordering the machine before demand is confirmed converts a reversible financing decision into a sunk-cost commitment. A staged approach-revolver first, capacity second-preserves flexibility.