1. 1 Corporate Finance: Understanding Growth Professor Scott Hoover Business Administration 221

2. 2 What is the optimal growth rate for a company?  A few simple assumptions: The firm 1. …wants to grow. 2. …does not want to issue new equity. 3. …wants to maintain its debt ratio and dividend policy.  Intuition An increase in sales typically requires an increase in assets.  must be a corresponding increase in liabilities and equity.  Why? …the balance sheet identity (A=D+E)  The increase in D+E must be from retained earnings and increases in debt (to keep D/TA constant).

3. 3  A few more assumptions… The net profit margin is constant over time. The firm intends to retain a fixed fraction (R) of its earnings and pay the rest out as dividends. The total asset turnover is constant over time. Suppose that sales increase from S 0 during one period to S 0 +  S the next. Are these realistic assumptions?  No.  But, we will reconsider our assumptions later.

4. 4  S (TA/S) = (NI/S)  (S 0 +  S)  R + (NI/S)  (S 0 +  S)  R  (D/E) S 0  last period sales  S  increase in sales from the last period TA/S  inverse of the total asset turnover R  earnings retention rate NI/S  net income / sales  net profit margin D/E  debt-to-equity ratio Notice that…  The left hand side of the equation is the change in assets  …the first term after the equality is the retained earnings for the firm (  equity).  …the second term after the equality is  equity times D/E, which is the change in debt necessary to maintain the same debt-to-equity ratio.

5. 5  Rearranging the equation  This is the only growth rate that the firm may have under the simple assumptions above. Note: This equation is for sales growth. If the profit margin is constant, it will also be for earnings growth. Note: The Higgins text presents a different formula. Under that formula, the company’s debt ratio will decrease if the profit margin is positive.

6. 6 To grow at a greater rate, one of more of the following must happen.  TA/S decreases (i.e., increase the asset turnover)  often difficult to achieve  NI/S increases  often difficult to achieve  D/E increases  may not be feasible or desirable  may decrease NI/S too much  R increases (i.e., cut dividends)  may send a negative signal to the market  Sell stock  dilutes ownership  may send a negative signal to the market

7. 7  Note: The textbook uses a similar, but less intuitive equation. Higgins notes that sales “should” grow at the same rate as equity, so g* can be estimated using the percentage change in equity.  E/E  g* = ROE  R = PM  AT  LM  R That formula cannot be applied over the long run because the basic ratios will not be constant.

8. 8  A firm might not be able to grow at g*. Why? Spending more on assets may not result in more sales. If a firm grows at a slower rate than g*…  When a firm grows slowly…. The firm generates excess cash. This can be problematic because the firm may use it unwisely. What can the firm do with the money?  Nothing!  This results in the firm stockpiling cash over time.  Increase dividends  Share repurchase  Acquisitions  New projects / R&D

9. 9 Note: It is possible for a firm to grow too fast.  This is not uncommon and sometimes leads to disastrous results.  Implication: It is critical to understand sustainable growth.  How is the sustainable growth rate best used? …to assess the firm’s potential for growth …to assess the possible need to issue stock/debt or buy back stock/debt Note that this becomes a highly subjective analysis.  must consider whether the company needs to add assets to generate sales  must consider things like excess cash -- a large cash account is a potential source for growth.