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©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Learning Objectives Understand how the sustainable growth model is derived and apply it to determine financing requirements for a new venture. Determine how the choice of financing facilitates the entrepreneur’s abilities to respond to product market success or failure and retain significant ownership of the venture under alternative product market outcomes. Understand how to design and use a cash-flow break- even analysis to assess the financial needs of a venture.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Topical Overview of Chapter Trade-offs between liquidity and value. Spontaneous financing and sustainable growth. Break-even analysis and financing needs. Simulating future performance and staging financing.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Differing Schools of Thought About Early Stage Financing: Arguments for raising as much money as possible: Liquidity (slack) is a cushion against unexpected setbacks Liquidity affords flexibility to pursue unexpected opportunities Liquidity makes obtaining credit from lenders and suppliers easier Liquidity is comforting for the entrepreneur and key employees

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Differing Schools of Thought About Early Stage Financing: Arguments against raising as much money as possible: Limiting investment limits the loss if the venture fails. Limiting investment disciplines the entrepreneur to focus on the objective. Limiting investment promotes developing cash- management skills. Limiting investment preserves ownership for the entrepreneur.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Sustainable Growth Model Definitions g -The annual percentage growth rate of equity. g* -The sustainable annual percentage growth rate of equity, given leverage and dividend policies and no additional outside equity financing. E -The level of equity book value in dollars at the beginning of a year.  E -The dollar-valued change in equity book value during the year. NI-Net income after tax for the year, expressed in dollars. R-The earnings retention rate, i.e., the fraction of net income after tax that is retained by the venture and not distributed to investors. ROE -The accounting rate of return on equity, i.e., net income after tax, divided by equity.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Sustainable Growth Model Definitions S-Sales revenue for the year. A- Book value of total assets at the beginning of the year. r-The effective interest rate on debt financing (all non- equity financing). t- The corporate income tax rate, divided by equity. ROE -The accounting rate of return on sales, i.e., the ratio of net income after tax to sales revenue. EBIT -Accounting net income for the year, before interest and income tax. Turnover - The ratio of sales revenue for the year to total assets at the beginning of the year. Leverage -Ratio of beginning assets to beginning equity.

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 The Sustainable Growth Model

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Financial Planning for a Venture With Sustainable Growth: An Example Operating leverage is 2:1 (i.e., S/A = 2.0). Pre-tax ROS is 10%. Tax rate is 35%, all earnings are to be retained. Available equity is $500,000. Objective is to achieve sales of $2.5 million in 5 years. Sustainable growth rate with no financial leverage: –g* =.1(1-.35) x 2.0 x 1.0 x 1.0 = 13%. Achievable sales level in 5 years is $1.842 million. What should be done?

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Relation Between Financial Leverage and Sustainable Growth Rate

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Annual Revenues, Expenses, and Cash Flows of Ink Magazine at Various Circulation Levels

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Net Income and Cash Flow Contribution Margins of Ink Magazine at Various Circulation Levels

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Ink Magazine Break-even Chart

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Ink Magazine Scenario Analysis

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 New Company Cumulative Frequency Distributions of Financing Needs at Various Times

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 New Company Simulation Results for Alternative Financing Decisions

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Sustainable Growth of Sales With Changes in Financial Leverage

©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 7 Evaluation of $500,000 of Initial Financing