Growth Rates and Financing Needed
Table of Contents
1 Growth Rates
This presentation will give you an idea of how the growth rate of the firm relates to financing required. Let's say you increase your firm's expected sales. Then:
- You will also need more assets to provide for the increased sales.
- An increase in assets will require an increase in the firm's liabilities and/or equity (remember the balance sheet identity).
The amount of assets required will affect the proportion of debt and equity required.
2 Importance
Understanding the relationship between growth and financing will help the firm set coherent goals. For example, you may hear a firm say they want to both increase sales and lower debt levels. Are these goals compatible? The following discussion will answer this question.
3 External Financing Needed (EFN)
Say we expect sales to increase by $\\(\Delta Sales\), and denote the firm's profit margin and dividend payout ratio by PM and d respectively. Define Variable Debt as the amount of debt that increases and decreases with assets. Pro. Sales is projected sales, and \(\Delta Sales\) is the projected change in sales. Lastly assume the amount of assets needed to generate a dollar in sales is constant over the range of sales we are considering (constant assets over sales ratio). Then for a given change in sales, the amount of external financing needed can be calculated by:
\(EFN = \frac{Assets}{Sales}\Delta Sales + \frac{Variable Debt}{Sales}\Delta Sales - PM(Pro. Sales)(1 - d)\)
4 Internal Growth Rate (IGR)
IGR is the maximum rate at which a firm can grow its assets using only internal financing (retained earnings). This means the firm cannot issue new debt or equity. The IGR is:
\(IGR = \frac{ROA(b)}{1 - ROA(b)}\)
where ROA is the firm's return on assets, and b is the firm's plowback ratio.
5 Sustainable Growth Rate (SGR)
IGR is the maximum rate at which a firm can grow its assets using internal financing, and issuing the amount of debt needed to keep its total-debt ratio constant.
\(SGR = \frac{ROE(b)}{1 - ROE(b)}\)
where ROE is the firm's return on equity, and b is the firm's plowback ratio.
SGR Calculator
| ROE: | |
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| Plowback Ratio: |
SGR:
6 Factors that Affect a Firm's Growth Rate
Now that we have equations for IGR and SGR, we can see the determinants of a firm's maximum growth rate. As a financial manager, knowing these relationships will allow you to make decisions while cognizant of the asset growth rate impacts.
For example, let's say your CEO wants to increase the dividend, what effect will that decision have on the firm's growth rate? In both IGR and SGR, increasing the dividend with reduce the plowback ratio. This in turn decreases the numerator, and increases the denominator, reducing the firm's maximum growth rate. So if you increase dividends, (1) the firm's growth rate will slow, or (2) the firm will have to seek external financing which affects its capital structure.
7 Self-Quiz Questions
1. Assume Utica Boiler Inc has a 15% ROE and 40% payout ratio. What is the maximum rate the firm can grow while maintining a constant total debt ratio and not selling any new stock?
2. Assume McCauley Ski Inc. has a 12% ROA and 20% payout ratio. What is the maximum rate the firm can grow using only internal financing?
3. If a firm increases its profit margin, its IGR and SGR _______.
8 Reading Ease Score
"Flesch-Kincaid reading ease score: 81.77 Easy (6th grade)"
"Flesch-Kincaid grade level score: 4.16"