Financial Policy and Growth

Based on our discussion just preceding, we see that there is a direct link between growth and external financing. In this section, we discuss two growth rates that are particularly useful in long-range planning.

The Internal Growth Rate The first growth rate of interest is the maximum growth rate that can be achieved with no external financing of any kind. We will call this the internal growth rate because this is the rate the firm can maintain with internal financing only. In Figure 4.1, this internal growth rate is represented by the point where the two lines cross. At this point, the required increase in assets is exactly equal to the addition to retained earnings, and EFN is therefore zero. We have seen that this happens when the growth rate is slightly less than 10 percent. With a little algebra (see Problem 30 at the end of the chapter), we can define this growth rate more precisely as:

Internal growth rate 5

where ROA is the return on assets we discussed in Chapter 3, and b is the plowback, or retention, ratio defined earlier in this chapter.

For the Hoffman Company, net income was \$66 and total assets were \$500. ROA is thus \$66/500 = 13.2%. Of the \$66 net income, \$44 was retained, so the plowback ratio, b, is \$44/66 = 2/3. With these numbers, we can calculate the internal growth rate as:

Internal growth rate

ROA X b 1 - ROA X b .132 X (2/3) = 1 - .132 X (2/3) = 9.65%

Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without external financing.

sustainable growth rate

The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio.

The Sustainable Growth Rate We have seen that if the Hoffman Company wishes to grow more rapidly than at a rate of 9.65 percent per year, then external financing must be arranged. The second growth rate of interest is the maximum growth rate a firm can achieve with no external equity financing while it maintains a constant debt-equity ratio. This rate is commonly called the sustainable growth rate because it is the maximum rate of growth a firm can maintain without increasing its financial leverage.

There are various reasons why a firm might wish to avoid equity sales. For example, as we discuss in Chapter 15, new equity sales can be very expensive. Alternatively, the current owners may not wish to bring in new owners or contribute additional equity. Why a firm might view a particular debt-equity ratio as optimal is discussed in Chapters 14 and 16; for now, we will take it as given.

Based on Table 4.8, the sustainable growth rate for Hoffman is approximately 20 percent because the debt-equity ratio is near 1.0 at that growth rate. The precise value can be calculated as (see Problem 30 at the end of the chapter):

Sustainable growth rate 5

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

CHAPTER 4 Long-Term Financial Planning and Growth

This is identical to the internal growth rate except that ROE, return on equity, is used instead of ROA.

For the Hoffman Company, net income was \$66 and total equity was \$250; ROE is thus \$66/250 = 26.4 percent. The plowback ratio, b, is still 2/3, so we can calculate the sustainable growth rate as:

Sustainable growth rate

ROE X b 1 - ROE X b .264 X (2/3) = 1 - .264 X (2/3) = 21.36%

Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year without external equity financing.

Sustainable Growth

Suppose Hoffman grows at exactly the sustainable growth rate of 21.36 percent. What will the pro forma statements look like?

At a 21.36 percent growth rate, sales will rise from \$500 to \$606.8. The pro forma income statement will look like this:

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