Lecture 6 & 7

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2013. Dr. Sohail Zafar

Lecture 6 & 7 :

Financial Planning Continues. External Funds Needed (EFN), Equation method, and statement method,

The difference between Constant Growth rate and Sustainable Growth rate of a Corporation

In the previous lectures you saw that if 5 corporate policies are kept unchanged then growth in OE equals

growth in sales which ultimately equals growth in share price. You also did a 4 – year financial planning

exercise showing how the g OE translates into growth in share price which is also called capital gains yield.

You also learnt that keeping a policy such as S/TA constant means both sales and TA should grow next

year at the same growth rate. But for the example the projected income statements and balance sheets

were made in the concise form.

In this lecture it will be shown that growth rate , g, measured as ROE (1 – d) is internally generated

constant growth rate in OE but it is not the sustainable growth rate for a company. When a company

grows at this constant growth rate it needs external financing, called EFN (external funds needed) because

when a policy such as capital structure as measured by TA/OE ratio is kept constant next year but OE

grows next year due to increase in RE then TA must also grow; and as both TA and OE would grow

therefore TL must also grow at the same growth rate only then next year’s balance sheet would be

balanced. But growth in TL means external debt financing as short term or long term loans would be

needed. And therefore this growth rate, ROE (1 - d), is not sustainable growth rate for a business

because it requires raising external financing in the form of loans, though no equity financing in the form

of issuing shares is needed because growth rate , g , has been defined as internally generated growth in

OE through increase in RE.

On the other hand the concept of sustainable growth rate is different from the concept of constant

growth rate. Truly sustainable growth rate of a co is that growth rate in sales next year where EFN

(external funds needed) are zero. That means no financing is needed by issuing shares or taking bank

loans, all financing comes as spontaneous increase in some CL and as increase in RE. Here again certain

policies are assumed to remain constant. To estimate sustainable growth rate of a co we assume that 4

policies remain constant: that is net profit margin (NI /S ratio), Turnover of TA ( S /TA ratio), dividends

payout ratio (DPS / EPS = d ), as well as number of shares outstanding are unchanged next year; but

Equity multiplier ratio (TA / OE ratio) of co, is not necessarily same as last year’s ratio.

In this lecture you shall learn to prepare full blown projected balance sheet , but we shall continue using

concise form of income statement.38


Exercise : Latest Balance Sheet Data ( beginning of 2010).

Cash 20 Acc P/A 20

R/A 30 Accruals 40

Inventory 100 ST Bank Loan 20

CA 150 CL 80

FA(net) 50 LT Loan 20

TA 200 TL 100

Share Capital 20

RE 80

OE 100

TL & OE 200

Latest Income Statement Data ( end of 2010)

Sales 500

NI 10

‘d’ 50%.

NI/S ratio = 10 /500 = 2%

ROE = NI /OEbeginning = 10 /100 = 10%

gOE = ROE ( 1 - d)

= 10 /100 (1 - 0.5)

= 10% * 0.5

= 5%

Question

Please prepare next year’s concise projected income statement at the end of 2011 and full blown

projected balance sheet at the beginning of 2011; and see if this Co grows next year’s at the constant

growth rate of 5% then would it need external financing ?

Let us define some CL as spontaneous CL as they automatically increase or decrease with sales. Included

in spontaneous CL are accounts payable and accrued operating expenses payables because to increase

sales more raw material is purchased and if terms of credit purchases are unchanged then there would be

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a commensurate increase in accounts payable; also due to higher production and sales, operating

expenses would also be higher resulting in higher accrued payables related to these operating expenses.

But short term bank loan , long term debt , and share capital on the RHS of balance sheet wont directly

change with changes in sales, nor would RE change spontaneously with increase in sales. Also for CA and

FA , we shall assume , they would change with sales; though in real life it is possible that increase in

production and sales can be supported by existing FA as they may still have un used capacity. Change in

current assets such as accounts receivables makes sense because as sales increases then accounts

receivables also increase proportionately if credit terms offered to customers are unchanged; similarly

inventory would proportionately increase to support higher levels of production and sales; and higher

sales would cause higher level of cash. Next year is year 1, so subscript 1 under various variables refers to

projected amounts, such as S1 is projected sales for next year and S0 is this year’s actual sales.

S1=S0 (1 + g)

S1=500 ( 1+ 0.05)

S1 = 525

Increase in S = S1 - So

=525 – 500 = 25

EFN = TFN – internally generated funds (TFN means total funds needed and refers to increase in TA)

EFN =[ TA/S ratio* increase in S] – [( spontaneous Liabilities/S ratio* increase in S ) + (NI/S ratio *S1(1 – d))]

TA/S ratio tells one rupee of sales need how much assets, and TA/S * increase in sales refers to amount of TA

needed to support increase in sales

Spontaneous liabilities / sales ratio tells one rupee of sales need how much of such liabilities; and multiplying this

ratio by increase in sales tells higher sales would cause how much increase in such liabilities

NI/S ratio tells one rupee of sales generates how much NI, multiplying this ratio with next year’s sales give estimate

of next year’s NI, and multiplying that with ( 1 - d) gives increase in RE next year

EFN =[ TA/S ratio* increase in S] – [( spontaneous Liabilities/S ratio* increase in S ) + (NI/S ratio *S1(1 – d))]

EFN =(200/500 * 25) - [(60/500 * 25) + (10/500*525*(1 – 0.5)]

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EFN =(0.4*25) - [(0.12*25) + (0.02*525*0.5)]

EFN = 10 -[(3 ) + (5.25)]

EFN = 10 - 8.25

EFN = 1.75 million.

So if this Co plan’s to grow its sales at constant growth rate of OE which is calculated above as 5% next

year then it would need external funds of 1.75 million rupees during the next year; such funds can be

raised by taking short term bank loan, long term loans, or issuing new shares. If co wants its capital

structure (TA/OE) to also remain constant then it would raise all these EFN as liabilities, but if it is decided

that the TA/OE need not remain constant then this co may decide to raise some or all of this EFN by

issuing shares and thus raising external equity funds, in that case its TA/OE ratio will fall compared to the

previous year and also its number of shares outstanding will increase.

The resulting Income statement and balance sheet are shown below, note the balance sheet will not

balanced initially until you show EFN. Thereafter you decide how the external funds would be raised, for

example as a combination of short term loan, long term loan, and issuance of new shares; after deciding

the sources of EFN next year you would get a balance sheet that is balanced.

Projected balance sheet and Income Statement at constant growth rate of 5%, whereas growth rate

was estimated using constant growth formula: g = ROE (1 – d)

Forecast for next year’s sales is S1=525.

NI/S ratio is 2%. Assuming its unchanged next year, so estimate for the next year is:

NI1=S1* 0.02, and that comes out

NI 1=525*2%=10.5 million rupees

Cash Dividends = NI 1 * d , assuming dividend payout ratio remains unchanged next year at 50%, then

= 10.5 * 0.5 = 5.25 m Rs

note the method shown above is also called Percentage of Sales Method because most of the items in

the balance sheet and income statement grow at the same growth rate as growth in sales, this happens

when we try to keep certain ratios same as last year; for example, TA to Sales or NI to Sales unchanged.

For example if Sales last year was 100 and NI was 25 than NI/ S ratio was 0.25 last year; and you plan to

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grow sales by 5% and want profitability as measured by NI /S ratio, unchanged then next year 100 + 5% =

105 is forecasted sale, and 25 + 5% = 26.25 is forecasted NI; now check the profit margin ratio for the next

year: NI1 / S1 = 26.25 / 105 , it is again 25% as it was last year . So whenever ratios of income statement

or balance sheet items with sales are kept constant then the respective items of income statement or

balance sheet grows at the same percentage as growth in sales. Since ratio of various items with sales is

kept constant to keep certain policies unchanged therefore this method is termed percentage of sales

method.

Forecasted balance sheet for the next year at 5% growth rate of OE

Total Assets

Cash 20(1+ 0.05)=21

R/A 30(1+ 0.05)=31.5S

Inventory 100(1+ 0.05)=105

FA 50(1+ 0.05)=52.5 (assuming FA are being used already at full capacity)

TA = 210

Total liabilities and OE

P/A=20*(1+ 0.05)= 21

Accruals=40(1+ 0.05)= 42

S.T.Bank= 20 (unchanged)

L.T. Loan= 20 (unchanged)

TL 103

Share Capital 20 (unchanged)

End RE 85.25 (see below how RE was estimated)

OE 105.25

TL+OE 208.25

(please note balance sheet is not balanced)

EFN or Plug 1.75

Total Liabilities and OE (after Plug) 210

Plug is used here to balance the balance sheet, since short fall is on the right side, or financing side, of

balance sheet, therefore external financing is needed, and it is EFN = TA – TL =210 – 208. 25 = 1.75. It

means to grow sales at 5%, increase in TA next year would exceed the increase in spontaneous liabilities

and internally generated increase in OE due to RE; and 1.75 million worth of increase in assets would have

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to be financed by raising external funds as short term , or long term loans, or as further increase in OE by

issuing new shares.

Please also note how Ending RE in the projected balance sheet above was calculated as shown below:

End RE= Beg RE + NI – cash div – stock div

ERE = 80 + 10.5 – 5.25 – 0

ERE = 85.25

Please note End OE in the projected balance sheet above confirms the statement of changes in OE :

End OE = Beg OE + NI- Cash dividends+ Shares issued- Shares Repurchased

105.25 = 100+ 10.5- 5.25+ 0 - 0

105.25 =

We know that if sales of this co grows next year at 5% growth rate, external financing would be needed

as EFN was 1.75 m Rs according to the equation method, now we saw that full balance sheet statement

method also gives the same EFN of 1.75 million Rs. Co’s management may decide to take short term bank

loan, or long term bank loan, or issue shares or a combination of these 3 options to raise 1.75 million

rupees during the next year ; but in any case additional assets needed (10 million rupees) for attaining

5% growth in sales are more than the funds that would be internally generated in the form of increase in

RE and increase in spontaneous liabilities (8.25 million)

Question :

Can we call 5% growth rate in sales as sustainable growth rate for this corporation , if no, why?

Answer:

Though ROE (1 - d) =g gave 5%, and we used it as growth rate for sales and also many other items in the

income statement (NI grew at 5%) and balance sheet, yet it is not sustainable growth rate because

company would need EFN of 1.75 million Rs to grow at that rate, whereas at the sustainable growth rate

in sales, the EFN should be zero.

Question

What is the sustainable growth rate of sales for this Co?

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Answer:

we know that at sustainable growth rate of sales the external funds needed (EFN) are zero.

Please remember from previous discussion that:

S1= So(1 + g)

Increase in Sales = S1 – So

Increase in Sales =So(1+ g) – So

Increase in Sales =So + So * g – So

Increase in Sales = So * g

Also note that last year TA/S ratio =200/500= 0.4, and it is assumed to remain the same next year

Last year’s Spontaneous Liabilities / Sales ratio =(accounts P/A+ Accruals) /S= 60/500=0 .12, and it is

assumed to remain the same next year

At sustainable growth rate EFN is zero, so to attain zero EFN let us solve the EFN equation for ‘g’ by

setting EFN at zero; it can be done by inserting Sog as increase in sales; and So (1 + g) in place of S1 ,as next

years sales in the EFN equation:

EFN =(TA/S ratio* increase in S) – [{ spontaneous Liab/S ratio* increase in S } + { NI/S ratio *S1(1 - d)}]

0 = (0.4 * So g) – [{0.12*So g + {0.02*(So(1 + g)(1- d)}]

0 = (0.4 * 500 g) – [(0.12 * 500 g) + (0.02 * {500(1 + g)} * (1 - 0.5)]

0 = 200g - [(60g +(0.02*(500 + 500g)*0.5)]

0 = 200g - [(60g + (5 + 5g)]

0 = 200g - [(65g + 5)]

0= 135g - 5

5= 135g

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g=5/135

g =0 .0370 = 3.7% per year

Sustainable growth rate in sales works out as shown above 3.7% for the next year, at this growth rate of

sales, external funds needed (EFN) would be zero. Though 5% was constant growth rate in sales while 5

policies were kept constant; but it was not sustainable growth rate because, as we saw above, to grow at

5% this co would need EFN of 1.75 million; whereas to grow at 3.7% it would not need any external funds

by taking loans or issuing shares.

Balance Sheet Statement method of forecasting next year’s balance sheet at sustainable growth rate of

3.7%

Equation for estimating EFN above gave sustainable growth rate (g) 3.7% . Now we shall use this growth

rate to make projected detailed balance sheet for the next year; and it would come out balanced, that is,

it would have both sides equal and no EFN plug would be needed. Growing at 3.7% , its sales for next year

are estimated to be:

S1 = So * (1 + g)

= 500 * ( 1 + 0.037)

= 518 million rupees

Please note that NI / S ratio was last year 10/500 = 0.02. And it is assumed that next year profit margin

ratio would be same; therefore

NI 1 / S 1 = 0.02

NI 1 = 0.02 * S1 .

NI 1 = 0.02 * 518 = 10.37 million. (or: NI1 = NI0(1 + g) = 10 (1.037) = 10.37 million)

It is also assumed that co’s dividend policy won’t change next year and would remain at 50% of NI paid

out as cash dividends. So dividends for the next year

Cash div = NI 1 * ‘d’

Cash div = 10.37 * 0.5

Cash div = 5.18 million Rs. (or: div1 = div0(1 + g) = 5 (1.037) = 5.18 million)

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Also it is assumed that FA are already operating at full capacity therefore further increase in production

would require increase not only in CA but also in FA .

Projected Total Assets Next year

Cash 20(1+ 0.037)=20.74

R/A 30(1+ 0.037)=31.11

Inventory 100(1+ 0.037)= 103.7

FA(net) 50(1+ 0.037)=51.8

TA =207.3

Projected Total liabilities and OE next year

Accounts P/A 20*(1+ 0.037)= 20.7

Accruals 40(1+ 0.037)= 41.5

S.T.Bank= 20 (unchanged)

L.T. Loan 20 (unchanged)

TL 102.2


RE 85.18 (see below how Re was estimated)

OE 105.18

TL+OE 207.3

Please note ending RE in the projected balance sheet at the end of next year was estimated as:

End RE = Beg RE + NI - Cash dividend - stock dividend

= 80 + 10.37 -5.18 - 0

=85.18

Please note that both sides of balance sheet are equal at 207.3, and there is no EFN or plug needed to

balance the balance sheet, which is a proof that 3.7% growth rate in sales for the next year is the

sustainable growth rate for this business. To attain this sustainable growth rate in sales it was assumed

that management of this company keeps it’s the following 5 policies constant, namely:

1. net income as percentage of sales ( also called net profit margin or profitability),

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2. total asset as percentage of sales 1 , which is a measure called asset productivity

3. dividend payout ratio (also called dividend policy),

4. number of shares outstanding constant;

5. but one more policy is also assumed to remain constant and that is spontaneous liabilities as

percentage of sales.

Please also note that there is no need to keep financial leverage as measured by TA/OE ratio and also

called capital structure and equity multiplier, constant. Under this method number of shares outstanding

are constant at the last year’s level because issuing shares would bring new cash and repurchase of shares

would need cash; and both these effects are not accounted for in this method as you saw above that

share capital is unchanged in the OE portion of the balance sheet of the last year and the projected

balance sheet of the next year. Also short term and long term loans are kept unchanged in the projected

balance sheet at the same level as in the last year’s balance sheet because by definition to grow at

sustainable growth rate the company should not need any further loans, nor should it need issuing new

shares to bring in fresh equity capital.

Please note carefully that although OE has increased in the projected balance sheet of the next year as

compared to the last year’s balance sheet, yet this increase is not achieved by bringing in external equity

through issuing new shares; rather it is attained due to increase in RE.

Statement method of forecasting next year’s balance sheet at 15% growth rate which is much higher

than sustainable growth rate of 3.7%

It is time for us to be more realistic than we have been up till now. In real life growth targets are set by

the company’s board of directors, and naturally they like to set high growth target. Therefore for the this

exercise let us suppose next year’s target growth rate of sales is set by the board of this co at 15% . Your

task is to prepare projected Income statement and balance sheet for the next year and estimate EFN using

the data originally given for the last year in the beginning of this lecture.

S1=S0 (1 + g )

S1=500(1+ 0.15)

1 please note inverse of S /TA ratio (TA turnover) is TA/S which was used here, that shows TA as %age of sales, and it is a measure of asset productivity; it is also a measure of capital intensity of a business because if more TA are needed to generate 1 rupee of sales then such a business is deemed capital intensive.)

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S1=575 million. In this case increase in sales next year is targeted at 575 – 500 = 75 million rupees

NI1/S1= 0.02 same ratio as last year

NI1 = 0.02*S1

NI1 = 0.02*575 =11.5million

Cash Dividends1 = NI1*d

Cash Dividends1 = 11.5* 0.5

Cash Dividends1 = 5.75 million

End RE = Beg RE + NI – Cash Div - stock Div

End RE = 80 + 11.5 - 5.75 – 0

End RE = 85.75 million

Projected Total Assets for next year

Cash 20(1+ 0.15)=23

R/A 30(1+ 0.15)=34.5

Inventory 100(1+ 0.15)=115

FA 50(1+ 0.15)=57.5

TA = 230

Projected Total liabilities and OE

Accounts P/A 20*(1+ 0.15) = 23

Accruals 40(1+ 0.15) = 46

S.T. Bank 20 (unchanged)

L.T. Loan 20 (unchanged)

TL 109


RE 85.75 (as calculated above)

OE 105.75

TL+OE 214.75

EFN = estimated TA - estimated TL & OE

EFN = 230 - 214.75

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EFN = 15.25 (Plug)

Please note the liabilities & OE side of balance sheet is a smaller total (214.75 million), that means

planned financing expected to be available next year is less than planned investment in TA (230 million),

and this shortage would have to be met by raising external funds of 15.25 million Rs. External funds can

be raised from three sources:

1) taking short term bank loan,

2) taking long term bank loan or issuing long term corporate bonds which are called in Pakistan TFCs(term

finance certificates),

3) issuing new shares to the existing shareholders called right issue or issuing new shares to general public

called seasoned issue.

Double check EFN using the equation method as shown below

EFN =( TA/S ratio* increase in S) – [( spontaneous Liabilities/S ratio* increase in S )+ [NI/S ratio *S1(1- d)]

EFN=(0.4*75) -[(0.12*75) + [0.02*575*(1- 0.5)]

EFN =30 -( 9 + 5.75)

EFN=30 - 14.75

EFN= 15.25 million.

So if board of directors gives a sales growth target of 15% for the next year, then as finance manager you

should be able to work out that this is a growth target which is much higher than the sustainable growth

rate of 3.7%. You should also be able to advise the board that to grow at 15% external financing of

15.25 million rupees in the form of issuance of equity shares and/or raising more debt as short term or

long term loans would be needed.

It is only common sense that faster growth of production and sales of a business requires more assets to

be put in place first; and that is why projected balance sheet in the beginning of year is prepared and sales

and NI at the end of the year is estimated. In this particular case an increase in assets of 30 million

rupees is total funds needed (TFN); while funds expected to be generated by automatic increase in CL and

by increase in RE are expected to be 14.75 million, therefore the difference of (30 - 14.75) = 15.25 million

will have to be financed through external sources of funds such as taking loans or issuing shares.

Whether taking loans (raising debt capital) or issuing shares (raising equity capital), or a combination

thereof is going to be opted as a source of external funds needed would be decided by top management,

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which is the board of directors, because this is considered a strategic decision needing input from the top

most level, as it has implications for capital structure, financial risk, WACC, and ultimately the valuation of

company’s share in the market. While board is making these choices it keeps in mind number of factors

such as the cost of these 2 types of capital, Kd (cost of debt capital) and Kc (cost of equity capital)

respectively; time involved to raise the required capital, effect on co’s capital structure and therefore on

co’s financial risk, insolvency risk, and bankruptcy risk; conditions in financial markets, effect on

company’s WACC and therefore ultimately on its valuation of shares because ROIC – WACC = EVA , and

increase in EVA means value creation , while decrease in EVA means value destruction, etc.

Usually if share prices are generally low in the market those days then that is not considered a good time

by any company to issue shares because to raise the required amount of funds relatively more shares will

have to be issued due to the prevailing low prices in the stock market. Also when interest rates are too

high then companies do not like to borrow in those times and prefer to defer their borrowing until

interest rates come down.

About prevailing low share price you must have this clarity of thinking that current low price of shares of a

business now means shareholders are demanding high Kc ; and as Kc is risk adjusted required rate of

return of shareholders , therefore it means shareholders are perceiving high risk and that is why

demanding high return, and consequently share price is currently low. Therefore :

High perceived risk by shareholders leads to shareholders demanding higher rate of return from shares of

such a company (Kc), which is clear from CAPM

Kc = Rf + (Rm - Rf) Beta levered

Here CAPM shows that higher the relevant risk (beta levered) of a share , higher is the rate of return (Kc)

demanded by the shareholders.

On the other hand higher Kc impacts current share price negatively, which becomes clear from DDM

formula given below wherein current share price is inversely related with required rate of return:

P0 = DPS1 / (Kc - g).

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Also remember that Kc is one component of WACC; similarly higher interest rates on loans means higher

Kd for the borrowing co, and Kd is also a component of WACC. As you know by now that keeping the

WACC low is always desirable for the management because higher WACC hurts value creation, therefore

management prefers to opt that source of financing or that combination of sources of financing that is

cheaper and does not cause WACC to go to high.

Another Exercise:

This exercise shows that 20% growth rate in sales is not sustainable growth rate for the co used in this

example, in fact you will see that it is too slow a growth rate for this company, because EFN is not zero,

rather it is negative for the next year when this co grows it sales at 20%. The latest relevant data from

balance sheet (beginning of year) and income statement( end of year) are given below in concise form:

TA = 500m,

S = 1000m,

Increase of 20% in sales means next year’s sales = 1,000(1.2) = 1,200

Increase in sales expected during next year = 1,200 - 1,000 = 200 million rupees

TA as %age of sales are 500/1000 = 0.5

CL = 200 m but out of that 50 million rupees is notes P/A to MCB, a short term loan. So spontaneous CL

are 200 – 50 =150m, and spontaneous liabilities as percentage of sales are 150/1000 = 0.15

NI =100m, so NI as %age of sales is 100/1000 = 0.1

Total Cash Dividends paid = 30m, so: d = div/NI = 30/100 = 0.3 or 30% payout.

Expected growth in sales is 20%

Please note that spontaneous CL are those current liabilities that increase or decrease automatically

(spontaneously) due to increase or decrease in sales , and such change in certain current liabilities

happens without any conscious deliberate effort on the part of the management. For example certain

operating expenses such as wages and salaries and utility expenses go up with sales going up, as these

expenses are incurred but not paid immediately thus accrued liabilities payable related to these expenses

automatically increase as sales increase’s; the same is true for accounts payable related to purchase of

raw materials. As higher sales requires higher production thus higher purchases of raw material inventory

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therefore resulting accounts payable go up in tandem with increase in sales. But short term bank loan

does not increase or decrease with sales automatically because taking loan is a deliberate conscious effort

on the part of management. Therefore short term bank loan is subtracted from CL to arrive at

spontaneous CL of a co. Therefore spontaneous CL are mostly composed of accounts payable and

accrued operating expenses payable

Find: 1. TFN (total funds needed) to expand TA to support growth in sales.

2. Funds generated by spontaneous increase in liability

3. Funds generated by increase in RE

4. Internally generated funds ( items 2 + 3 above)

5. EFN ( external funds needed) ( Item 1 - 4 above)

Equation Method for Estimating EFN at 20% growth rate in Sales:

There are various ways of stating the EFN equation , three are given below.

EFN =TFN – ( internally generated financing)

EFN =TFN - (Finances generated from spontaneous Liab + Finances generated from increase in RE)

EFN = [TA/S ratio * Change in S] – [(Spontaneous Liab /S ratio * Change in S) + {NI/S ratio * S1(1- d)}]

EFN = [0.5*200] - [(0.15*200) + {(0.1*1200(1 - 0.3)}]

EFN = 100 -[(30 ) + ( 84)]

EFN = 100 - 114

EFN = -14 Million

Negative EFN of 14 million for next year means that 20% growth in sales can be achieved without raising

external funds in the form of issuing shares, or issuing bonds, or taking short term or long term bank loan.

Rather at the 20% growth in sales, this co would need additional investment of 100 million in TA but it is

likely to experience additional financing of 114 million due to automatic increase in CL and increase in RE.

Therefore it is expected to have by the end of next year 14 million Rs excess internally generated financing

which it would have a choice to use to repay existing loans / liabilities, or it can use these funds to pay

higher cash dividends, or to repurchase shares, or even to further expand its assets, or if management has

no good ideas then it would simply result in additional 14 million sitting on the asset side as cash. So 20%

growth in sales is not sustainable growth rate for this company because at sustainable growth rate EFN

should be zero, here EFN is -14 million, so this growth rate is much slower than sustainable growth rate of

this co; this co can afford to grow much faster than 20% without needing external financing.

Home Work

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1. Please determine how much external funds would be needed if this co plans to grow at 60% growth

rate

2. Please determine sustainable growth rate of sales of this company.

Answers to home work exercise

1) At 60% growth rate EFN?

EFN = (TA/S * Sog)- {(Spontaneous CL/S*Sog)+ {NI/S*So(1+g)}(1-d)]

= (0.5*1,000*0.6) - {(0.15*1,000*0.6) + (0.1*1,000)(1+0.6)(1- 0.3)}

=300 - {90 + 112}

= 300 – 202 =98 million rupees

external funds would be needed if this company plans to grow at 60% growth rate.

2) Sustainable growth rate of their company?

3) EFN = (TA/S * Sog) - {(Spontaneous CL/S*Sog)+(NI/S*So(1+g)(1- d)}

EFN = (0.5*1,000*g) - {(0.15*1,000*g) + {0.1*1,000(1+g)}(1- 0.3)}

0 = 500g - {150g + (100+ 100g)*.7}

0 = 500g – {150g + 70+ 70g}

0 = 500 g -150 g -70 -70g

70 = 280 g

0.25 = g

Sustainable growth rate of sales for this company is 25% . As you saw 20% growth rate is too slow but

60% is too fast , 25% is sustainable growth rate in sales for the next year. Again do not forget the

assumptions: net profit margin, dividend payout ratio, number of shares outstanding, spontaneous CL as

percentage of sales, and TA as percentage of sales were assumed to be constant. Therefore in most text

books, this method is termed percentage of sales method of forecasting income statement and balance

sheet. And using this percentage of sales method you can solve for sustainable growth rate of sales of a

corporation by inserting zero as EFN and solving for g, as was done above.

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Lecture 6 & 7

Documents

Transcript of Lecture 6 & 7