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Hi,
In the December 2010 exam, Question 2: Nugfer, the company wants to raise $200m to acquire a competitor.
Reading the examiner’s report, it says:
“The question said that the current assets of the company did not include any cash, but many answers suggested that $121 million of the $200 million needed could be provided from $1321 million of retained earnings in the balance sheet. As the company had no cash, this was of course not possible and shows a misunderstanding of the nature of retained earnings.”
Can you please explain why please?
I feel like I don’t know what retained earnings are now!Thanks,
Spencer.- Topics: 0
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For F9, when question says “use retained earnings* to finance an investment,” they are talking about using the saved-up cash the company has from operations (‘cash’ found in the SoFP in current assets.)
Sometimes the jargon makes this sound confusing, but it’s straight-forward; the Pecking Order theory sums it up:
Three options for funding a new investment:
1) Retained earnings
(use the cash we have — this is what they are talking about in the question, the company doesn’t have any cash, so they can’t use this option.)2) Debt
(Get cash by taking a loan or issuing bonds)3) Equity
(get cash by issuing shares)* Retained earnings = accumulated profits = Bottom line of this year’s income statement added to what we’ve accumulated so far (found in the EQUITY section of the SoFP ‘retained earnings’ or ‘accumulated profit’). In the context of this question, it’s the cash from retained earnings we are talking about.
Thanks Steve, I think I get it now.
The “Retained earnings” figure of £121m in the SoFP is the accumulated profits of the company. For investment, the figure must come from the “Cash” figure in the SoFP, which Nugfer in this question does not have.
Thanks again.
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you’re welcome
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