Chapter03

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Unformatted text preview: 17, 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 28 at the end of the chapter): Sustainable growth rate ROE b ______________ 1 ROE b [3.24] CHAPTER 3 Financial Statements Analysis and Long-Term Planning 75 ros82361_ch03.indd 75 5/27/08 10:15:11 AM Confirming Pages 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 b ______________ 1 ROE b .264 (2 3) __________________ 1 .264 (2 3) 21.36% Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year without external equity financing. EXAMPLE 3.6 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: HOFFMAN COMPANY Pro Forma Income Statement Sales (projected) Costs (80% of sales) Taxable income Taxes (34%) Net income Dividends Addition to retained earnings $606.8 485.4 $121.4 41.3 $ 80.1 $26.7 53.4 We construct the balance sheet just as we did before. Notice, in this case, that owners’ equity will rise from $250 to $303.4 because the addition to retained earnings is $53.4. HOFFMAN COMPANY Pro Forma Balance Sheet Assets $ Current assets Net fixed assets Total assets $242.7 364.1 $606.8 PERCENTAGE OF SALES 40% 60 100% Total debt Owners’ equity Total liabilities and owners’ equity External financing needed Liabilities and Owners’ Equity $ $250.0 303.4 $553.4 $ 53.4 PERCENTAGE OF SALES n/a n/a n/a n/a As illustrated, EFN is $53.4. If Hoffman borrows this amount, then total debt will rise to $303.4, and the debt-equity ratio will be exactly 1.0, which verifies our earlier calculation. At any other growth rate, something would have to change. 76 PART 1 Overview ros82361_ch03.indd 76 7/7/08 3:59:08 PM Confirming Pages DETERMINANTS OF GROWTH Earlier in this chapter, we saw that the return on equity, ROE, could be decomposed into its various components using the Du Pont identity. Because ROE appears so prominently in the determination of the sustainable growth rate, it is obvious that the factors important in determining ROE are also important determinants of growth. From our previous discussions, we know that ROE can be written as the product of three factors: ROE Profit margin Total asset turnover Equity multiplier If we examine our expression for the sustainable growth rate, we see that anything that increases ROE will increase the sustainable growth rate by making the top bigger and the bottom smaller. Increasing the plowback ratio will have the same effect. Putting it all together, w...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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