TOPIC: ESTIMATING SUSTAINABLE SALES GROWTH RATES Question: At what Percentage Rate can a Firm’s Sales Grow before It Needs to Issue New Common Stock, Assuming no Change in Operating Performance and Financial Policies? RW Melicher Ibanking 2013

A. Why is Sales Growth Important? Higher growth rates allow for possible economies of scale in production and distribution For commodity-type businesses, it is important to grow sales at least at the industry average to maintain market share Firm value will be increased if higher growth rates result in higher profits and larger free cash flows

B. Basic Concept Sustainable sales growth rate (g): Rate at which a firm can grow based on the retention of its profits in the business. In other words, a firm can grow its sales at the rate it increases its equity on a percentage basis each year g = Change in Equity/Beginning Equity where: Change in Equity is: (Ending Equity – Beginning Equity

C. Sustainable Sales Growth Assumptions: a constant operating performance, a target capital structure, a target dividend policy, and no new stock sales] Change in Equity = Net Income (NI) x Retention Rate (RR) where: RR is the proportion of net income retained in the firm g = (NI/Beginning Equity) x RR

D. Sustainable Sales Growth Rate Model Putting It Together: g = Operating Performance x Financial Policies Where: Operating Performance = Net Income/Net Sales x Net Sales/Total Assets Financial Policies = Total Assets/Beginning Equity x (Net Income – Dividends)/Net Income Alternatively, g = Profit Margin x Assets Turnover x Beginning Equity Multiplier x Retention Rate

E. Three Sales Growth Scenarios Actual Growth = Sustainable Growth --cash sources and uses are in balance Actual Growth > Sustainable Growth --cash deficits Actual Growth < Sustainable Growth --cash surpluses

F. Choices when Actual Growth Exceeds Sustainable Growth Sell New Equity Increase Financial Leverage Reduce the Dividend Payout Ratio Restructure Assets (sell marginal operations [focus on core businesses] and/or out-source selected activities) Explore Price-Volume Relationships Merge (find a partner with excess funds)

G. Choices when Sustainable Growth Exceeds Actual Growth Conduct Business as Usual (BAU) [Potential problems include excess cash and/or poor investment decisions] Return Excess Cash to Shareholders [Increase dividends and/or repurchase shares] Acquire Growth [Evidence suggests that “benefits” from merging high-growth and low-growth firms are suspect]