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Unformatted text preview: ussion shows, whether a firm runs a cash surplus or deficit depends on growth. Microsoft is a good example. Its revenue growth in the 1990s was amazing, averaging well over 30 percent per year for the decade. Growth slowed down noticeably over the 2000–2004 period, but nonetheless, Microsoft’s combination of growth and substantial profit margins led to enormous cash surpluses. In part because Microsoft paid few or no dividends, the cash really piled up; in 2007, Microsoft’s cash horde exceeded $24 billion. 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 3.2, 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 28 at the end of the chapter), we can define this growth rate more precisely as:
Internal growth rate ROA b ______________ 1 ROA b [3.23] where ROA is the return on assets we discussed earlier, and b is the plowback, or retention, ratio also 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 percent. 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 b ______________ 1 ROA b .132 (2 3) __________________ 1 .132 (2 3) 9.65% Thus, the Hoffman Company can expand at a maximum rate of 9.65 percent per year without external financing. 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, new equity sales can be very expensive because of the substantial fees that may be involved. 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 15; for now, we will take it as given. Based on Table 3....
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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.
- Summer '09