With this assumption, Rosengarten's pro forma income statement is as shown in Table 4.2. The effect here of assuming that costs are a constant percentage of sales is to assume that the profit margin is constant. To check this, notice that the profit margin was $132/1,000 = 13.2%. In our pro forma, the profit margin is $165/1,250 = 13.2%; so it is unchanged.

Next, we need to project the dividend payment. This amount is up to Rosengarten's management. We will assume Rosengarten has a policy of paying out a constant fraction of net income in the form of a cash dividend. For the most recent year, the dividend payout ratio was:

Dividend payout ratio

Cash dividends/Net income $44/132 = 33 1/3%

dividend payout ratio

The amount of cash paid out to shareholders divided by net income.

We can also calculate the ratio of the addition to retained earnings to net income as:

Addition to retained earnings/Net income = $88/132 =66 2/3%

This ratio is called the retention ratio or plowback ratio, and it is equal to 1 minus the dividend payout ratio because everything not paid out is retained. Assuming that the payout ratio is constant, the projected dividends and addition to retained earnings will be:

Projected dividends paid to shareholders = $165 X 1/3 = $ 55 Projected addition to retained earnings = $165 X 2/3 = 110

retention ratio

The addition to retained earnings divided by net income. Also called the plowback ratio.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

II. Financial Statements and Long-Term Financial Planning

4. Long-Term Financial Planning and Growth

© The McGraw-Hill Companies, 2002


PART TWO Financial Statements and Long-Term Financial Planning

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