Chapter 06 Financial Planning and Forecasting

CHAPTER 06—FINANCIAL PLANNING AND FORECASTING
1. The first, and most critical, step in constructing a set of forecasted financial statements is the sales forecast.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-2 The Sales
Forecast
TOPICS: Sales forecast
KEYWORDS: Bloom’s: Knowledge
2. A typical sales forecast, though concerned with future events, will usually be based on recent historical trends and
events as well as on forecasts of economic prospects.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-2 The Sales Forecast
KEYWORDS: Bloom's: Comprehension
3. Errors in the sales forecast can be offset by similar errors in costs and income forecasts. Thus, as long as the errors are
not large, sales forecast accuracy is not critical to the firm.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-2 The Sales Forecast
4. As a firm's sales grow, its current assets also tend to increase. For instance, as sales increase, the firm's inventories
generally increase, and purchases of inventories result in more accounts payable. Thus, spontaneously generated funds
arise from transactions brought on by sales increases.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-3 The AFN Equation
TOPICS: Spontaneously gen. funds
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5. The term "spontaneously generated funds" generally refers to increases in the cash account that result from growth in
sales, assuming the firm is operating with a positive profit margin.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: EASY
6. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally
large decrease in some other asset.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
TOPICS: Asset increase
7. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it
will require some amount of external funding.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: EASY
TOPICS: Additional funds needed
8. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which
represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are
uses of funds.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: EASY
TOPICS: Additional funds
needed

9. When developing forecasted financial statements there are some inputs that management controls such as the growth
rate and operating costs/sales ratio, while other inputs such as the tax rate and interest rate are not under its control.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-4 Forecasted Financial Statements
TOPICS: Forecasted statements
10. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and
if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
11. A firm's profit margin is 5%, its debt ratio is 56%, and its dividend payout ratio is 40%. If the firm is operating at less
than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full
capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external
financing.
a. True
b. False
ANSWER: False
POINTS: 1
12. Two firms with identical capital intensity ratios are generating the same amount of sales. However, Firm A is
operating at full capacity, while Firm B is operating below capacity. If the two firms expect the same growth in sales
during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant.
a. True
b. False
ANSWER: True
POINTS: 1
TOPICS: Capital intensity ratio

13. If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the
amount of additional funds required, other things held constant.
a. True
b. False
ANSWER: False
POINTS: 1
14. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the
firm to forecast those accounts on a continual basis.
a. True
b. False
ANSWER: False
POINTS: 1
REFERENCES: 6-4 Forecasted Financial Statements
TOPICS: Financial forecasting
15. When we use the AFN equation to forecast the additional funds needed (AFN), we are implicitly assuming that all
financial ratios are constant. If financial ratios are not constant, regression techniques can be used to improve the financial
forecast.
a. True
b. False
ANSWER: True
POINTS: 1
REFERENCES: 6-5 Using Regression to Improve
Forecasts
TOPICS: AFN and linear regression
16. Which of the following is NOT a key element in strategic planning as it is described in the text?
a. The mission statement.
b. The statement of the corporation's
scope.
c. The statement of cash flows.
d. The statement of corporate objectives.
e. The operating plan.
ANSWER: c
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-1 Strategic Planning
TOPICS: Strategic planning
OTHER: Multiple Choice: Conceptual
17. Which of the following assumptions is embodied in the AFN equation?

a. All balance sheet accounts are tied directly to sales.
b. Accounts payable and accruals are tied directly to sales.
c. Common stock and long-term debt are tied directly to sales.
d. Fixed assets, but not current assets, are tied directly to
sales.
e. Last year's total assets were not optimal for last year's sales.
ANSWER: b
POINTS: 1
DIFFICULTY: EASY
TOPICS: AFN equation
KEYWORDS: Bloom's: Analysis
18. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being
equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?
a. A sharp increase in its forecasted sales.
b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier
whose terms are 3/15, net 35.
e. The company discovers that it has excess capacity in its fixed assets.
ANSWER: a
RATIONALE: Answer a is obviously correct. Also, note that with purchase terms of 1/5 net 90, the nominal cost of non-
free trade credit is only 4.34%, whereas with 3/15, net 35, the nominal cost of trade credit is over 56%.
Therefore, the firm should have been taking discounts originally, hence should have had few accounts
payable, whereas it would probably not take discounts and thus have more accounts payable with the
new supplier. That change would lower its AFN.
POINTS: 1
DIFFICULTY: EASY/MODERATE
KEYWORDS: Bloom's: Evaluation
19. The term "additional funds needed (AFN)" is generally defined as follows:
a. Funds that are obtained automatically from routine business transactions.
b. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new
stock, to support operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new
assets needed to support growth.
e. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held
constant.
ANSWER: b
POINTS: 1
20. The capital intensity ratio is generally defined as follows:

a. Sales divided by total assets, i.e., the total assets turnover ratio.
b. The percentage of liabilities that increase spontaneously as a percentage of
sales.
c. The ratio of sales to current assets.
d. The ratio of current assets to sales.
e. The amount of assets required per dollar of sales, or A0*/S0.
ANSWER: e
POINTS: 1
21. Which of the following is NOT one of the steps taken in the financial planning process?
a. Assumptions are made about future levels of sales, costs, and interest rates for use in the forecast.
b. The entire financial plan is reexamined, assumptions are reviewed, and the management team considers how
additional changes in operations might improve results.
c. Projected ratios are calculated and analyzed.
d. Develop a set of projected financial statements.
e. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize
profits for our firm and its competitors.
ANSWER: e
POINTS: 1
TOPICS: Financial planning

22. Spontaneously generated funds are generally defined as follows:
a. Assets required per dollar of sales.
b. A forecasting approach in which the forecasted percentage of sales for each item is held constant.
c. Funds that a firm must raise externally through borrowing or by selling new common or preferred stock.
d. Funds that arise out of normal business operations from its suppliers, employees, and the government, and
they include spontaneous increases in accounts payable and accruals.
e. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital
expenditures and working capital needed to support the firm's growth.
ANSWER: d
POINTS: 1
23. A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the
additional capital that it must raise. Which of the following conditions would cause the AFN to increase?
a. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it
actually has excess capacity.
b. The company increases its dividend payout ratio.
c. The company begins to pay employees monthly rather than weekly.
d. The company's profit margin increases.
e. The company decides to stop taking discounts on purchased materials.
ANSWER: b
POINTS: 1
24. Which of the following statements is CORRECT?

a. Perhaps the most important step when developing forecasted financial statements is to determine the
breakdown of common equity between common stock and retained earnings.
b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales.
c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial
compensation program, where management's historical performance is evaluated.
d. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets.
e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially
if fixed assets are lumpy and economies of scale exist.
ANSWER: b
POINTS: 1
REFERENCES: Comprehensive
TOPICS: Forecasting concepts

a. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or strategies for
achieving its goals. The statement of corporate strategies sets forth detailed plans rather than broad approaches
for achieving a firm's goals.
b. A firm's corporate purpose states the general philosophy of the business and provides managers with specific
operational objectives.
c. Operating plans provide management with detailed implementation guidance, consistent with the corporate
strategy, to help meet the corporate objectives. These operating plans can be developed for any time horizon,
but many companies use a 5-year horizon.
d. A firm's mission statement defines its lines of business and geographic area of operations.
e. The corporate scope is a condensed version of the entire set of strategic plans.
ANSWER: c
POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
TOPICS: Strategic planning

a. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as
calculated by the AFN equation must also increase.
b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets.
Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both
fixed and current assets.
c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth.
d. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and
common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to
obtain them.
e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN.
ANSWER: d
POINTS: 1

a. Any forecast of financial requirements involves determining how much money the firm will need, and this
need is determined by adding together increases in assets and spontaneous liabilities and then subtracting
operating income.
b. The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet.
Although a forecasted income statement may help clarify the results, income statement data are not essential
because funds needed relate only to the balance sheet.
c. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy
does not affect the AFN forecast.
d. A negative AFN indicates that retained earnings and spontaneous capital are far more than sufficient to finance
the additional assets needed.
e. If assets and spontaneously generated liabilities are not projected to grow at the same rate as sales, then the
AFN method will provide more accurate forecasts than the projected financial statement method.
ANSWER: d
POINTS: 1

a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external
funds. In other words, it is the growth rate at which the firm's AFN equals zero.
b. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be
impossible for the firm's AFN to be negative.
c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually
decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN.
d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be
zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio.
e. Dividend policy does not affect the requirement for external funds based on the AFN equation.
ANSWER: a
POINTS: 1
TOPICS: AFN equation

a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A 0*/S0 and L0*/S0)
vary from year to year in a stable, predictable manner.
b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is
more appropriate than if assets are relatively small and can be added in small increments as sales grow.
c. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the
financial forecasting process.
d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed
assets.
e. Regression techniques cannot be used in situations where excess capacity or economies of scale exist.
ANSWER: c
POINTS: 1
REFERENCES: 6-5 Using Regression to Improve
Forecasts
TOPICS: Forecasting fin. reqmts.
30. Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being operated at
80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?
a. $312.5
b. $328.1
c. $344.5
d. $361.8
e. $379.8
ANSWER: a
RATIONALE: Sales $250
Fixed assets $75.0
% of capacity utilized 80.0%
Full capacity sales = Actual sales/% of capacity used = $312.5

POINTS: 1
DIFFICULTY: EASY
TOPICS: Excess capacity
OTHER: Multiple Choice: Problem
31. Kamath-Meier Corporation's CFO uses this equation, which was developed by regressing inventories on sales over the
past 5 years, to forecast inventory requirements: Inventories = $22.0 + 0.125(Sales). The company expects sales of $400
million during the current year, and it expects sales to grow by 30% next year. What is the inventory forecast for next
year? All dollars are in millions.
a. $74.6
b. $78.5
c. $82.7
d. $87.0
e. $91.4
ANSWER: d
RATIONALE: Current year's sales $400
Growth rate 30%
Projected Sales $520.0
Required inventories = $22.0 + 0.125 × Projected sales

= $22.0 + 0.125 × $520.0
= $87.0
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 6-5 Using Regression to Improve Forecasts
TOPICS: Forecasting inv.–regression
KEYWORDS: Bloom's: Application
32. Last year Wei Guan Inc. had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of
capacity. In millions, by how much could Wei Guan's sales increase before it is required to increase its fixed assets?
a. $170.09
b. $179.04
c. $188.46
d. $197.88
e. $207.78
ANSWER: c
Fixed assets (not used in calculations) $270
% of capacity utilized 65%
Sales at full capacity = Actual sales/% of capacity used = $538.46
Additional sales without adding FA = Full capacity sales − Actual sales = $188.46
POINTS: 1
33. Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only
60% of capacity. What is the maximum sales growth rate the company could achieve before it had to increase its fixed
assets?
a. 54.30%
b. 57.16%
c. 60.17%
d. 63.33%
e. 66.67%
ANSWER: e
Fixed assets (not used in calculations) $425
Sales at full capacity = Actual sales/% of capacity used = $1,416.67
Additional sales without adding FA = Full capacity sales − Actual
$566.67
sales =
Percent growth in sales = Additional sales/Old sales = 66.67%

POINTS: 1
34. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its Fixed Assets/Sales ratio
was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial
forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the
level it would have had had it been operating at full capacity. What target Fixed Assets/Sales ratio should the company
set?
a. 28.5%
b. 30.0%
c. 31.5%
d. 33.1%
e. 34.7%
ANSWER: b
Fixed assets $100
Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = 30.0%

POINTS: 1
TOPICS: Finding target FA/S ratio
35. Fairchild Garden Supply expects $600 million of sales this year, and it forecasts a 15% increase for next year. The
CFO uses this equation to forecast inventory requirements at different levels of sales: Inventories = $30.2 + 0.25(Sales).
All dollars are in millions. What is the projected inventory turnover ratio for the coming year?
a. 3.40
b. 3.57
c. 3.75
d. 3.94
e. 4.14
ANSWER: a
RATIONALE: Current year's sales $600
Growth rate 15%
Projected sales $690
Req. inventories = $30.2 + 0.25 × Projected sales

= $30.2 + 0.25 × $690.0 = $202.7
Inventory turnover = Sales/Inventories = 3.40

POINTS: 1
REFERENCES: 6-5 Using Regression to Improve Forecasts
TOPICS: Forecasting inv. turnover

36. Clayton Industries is planning its operations for next year. Ronnie Clayton, the CEO, wants you to forecast the firm's
additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the
AFN for the coming year? Dollars are in millions.
Last year's sales = S0 $350 Last year's accounts payable $40

Sales growth rate = g 30% Last year's notes payable $50
Last year's total assets = A0* $500 Last year's accruals $30
Last year's profit margin = PM 5% Target payout ratio 60%
a. $102.8
b. $108.2
c. $113.9
d. $119.9
e. $125.9
ANSWER: d
RATIONALE: Last year's sales = S0 $350
Sales growth rate = g 30%
Forecasted sales = S0 × (1 + g) $455
ΔS = change in sales = S1 − S0 = S0 × g $105
Last year's total assets = A0* = A0* since full capacity $500
Forecasted total assets = A1* = A0* × (1 + g) $650
Last year's accounts payable $40
Last year's notes payable. Not spontaneous, so does not enter AFN
$50
calculation
Last year's accruals $30
L0* = payables + accruals $70
Profit margin = PM 5.0%
Target payout ratio 60.0%
Retention ratio = (1 − Payout) 40.0%
AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout)

AFN = $150.0 − $21.0 − $9.1 = $119.9
POINTS: 1
TOPICS: Positive AFN
37. Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's
additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the
AFN for the coming year?
Last year's sales = S0 $200,000 Last year's accounts payable $50,000

Sales growth rate = g 40% Last year's notes payable $15,000
Last year's total assets = A0* $135,000 Last year's accruals $20,000
Last year's profit margin = PM 20.0% Target payout ratio 25.0%
a. −$14,440
b. −$15,200
c. −$16,000
d. −$16,800
e. −$17,640
ANSWER: c
RATIONALE: Last year's sales = S0 $200,000
Forecasted sales = S0 × (1 + g) $280,000
ΔS = change in sales = S1 − S0 = S0 × g $80,000
Last year's total assets = A0* = A0* since full capacity $135,000
Forecasted total assets = A1* = A0* × (1 + g) $189,000
Last year's accounts payable $50,000
Last year's notes payable. Not spontaneous,
so does not enter AFN calculation $15,000
Last year's accruals $20,000
L0* = payables + accruals $70,000
Profit margin = PM 20.0%
Target payout ratio 25.0%
Retention ratio = (1 − Payout) 75.0%

AFN = $54,000 − $28,000 − $42,000 = −$16,000
POINTS: 1
TOPICS: Negative AFN
38. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to
forecast the firm's additional funds needed (AFN). Data for use in the forecast are shown below. However, the CEO is
concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the
firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming
year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.
Last year's sales = S0 $300.0 Last year's accounts payable $50.0

Sales growth rate = g 40% Last year's notes payable $15.0
Last year's total assets = A0* $500.0 Last year's accruals $20.0
Last year's profit margin = PM 20.0% Initial payout ratio 10.0%
a. $31.9
b. $33.6
c. $35.3
d. $37.0
e. $38.9
ANSWER: b
RATIONALE: Last year's sales = S0 $300
Forecasted sales = S0 × (1 + g) $420
ΔS = change in sales = S1 − S0 = S0 × g $120
Last year's total assets = A0* = A0* since full capacity $500
Forecasted total assets = A1* = A0* × (1 + g) $700
Last year's accounts payable $50
Last year's notes payable. Not spontaneous,
so does not enter AFN calculation $15
Last year's accruals $20
L0* = payables + accruals $70
Profit margin = PM 20%
Initial payout ratio 10%
New payout ratio 50%
Initial retention ratio = (1 − Payout) 90%
New retention ratio = (1 − Payout) 50%

Old AFN = $200.0 − $28.0 − $75.6 = $96.4
New AFN = $200.0 − $28.0 − $42.0 = $130.0
Change in AFN = $33.6
POINTS: 1
TOPICS: AFN–changing div. payout
39. Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so its Fixed Assets/Sales ratio
was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been able to sell off enough of
its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much
cash (in millions) would it have generated?
a. $74.81
b. $78.75
c. $82.69
d. $86.82
e. $91.16
ANSWER: b
Fixed assets $225
Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = 32.50%
Optimal FA = Sales × Target FA/Sales ratio = $146.25
Cash generated = Actual FA − Optimal FA = $78.75
POINTS: 1
DIFFICULTY: CHALLENGING
TOPICS: Finding target FA/S ratio

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CHAPTER 06—FINANCIAL PLANNING AND FORECASTING

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17. Which of the following assumptions is embodied in the AFN equation?

20. The capital intensity ratio is generally defined as follows:

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24. Which of the following statements is CORRECT?

25. Which of the following statements is CORRECT?

26. Which of the following statements is CORRECT?

27. Which of the following statements is CORRECT?

28. Which of the following statements is CORRECT?

29. Which of the following statements is CORRECT?

Full capacity sales = Actual sales/% of capacity used = $312.5

Required inventories = $22.0 + 0.125 × Projected sales

Percent growth in sales = Additional sales/Old sales = 66.67%

Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = 30.0%

Req. inventories = $30.2 + 0.25 × Projected sales

Inventory turnover = Sales/Inventories = 3.40

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Last year's sales = S0 $350 Last year's accounts payable $40

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout)

Last year's sales = S0 $200,000 Last year's accounts payable $50,000

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout)

Last year's sales = S0 $300.0 Last year's accounts payable $50.0

AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout)

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AFN = (A0/S0)ΔS − (L0/S0)ΔS − Profit margin × S1 × (1 − Payout)

AFN = (A0/S0)ΔS − (L0/S0)ΔS − Profit margin × S1 × (1 − Payout)

AFN = (A0/S0)ΔS − (L0/S0)ΔS − Profit margin × S1 × (1 − Payout)