Based on our preceding discussion, 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 Page 108earnings, 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 31 at the end of the chapter), we can define this growth rate more precisely:
internal growth rate The maximum growth rate a firm can achieve without external financing of any kind.
Here, 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:
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, 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.
sustainable growth rate The maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt–equity ratio.
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 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 (see Problem 31 at the end of the chapter):
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 follows:
Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year without external equity financing.
EXAMPLE 4.2 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:
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.
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.
Determinants of Growth In the last chapter, we saw that the return on equity, ROE, could be decomposed into its various components using the DuPont 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 Chapter 3, 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, what we have is that a firm’s ability to sustain growth depends explicitly on the following four factors:
1. Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth.
Page 1102. Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth.
3. Financial policy: An increase in the debt–equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate.
4. Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.
The sustainable growth rate is a very useful planning number. What it illustrates is the explicit relationship between the firm’s four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its dividend policy as measured by the retention ratio, and its financial policy as measured by the debt–equity ratio.
Given values for all four of these, there is only one growth rate that can be achieved. This is an important point, so it bears restating:
If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate.
As we described early in this chapter, one of the primary benefits of financial planning is that it ensures internal consistency among the firm’s various goals. The concept of the sustainable growth rate captures this element nicely. Also, we now see how a financial planning model can be used to test the feasibility of a planned growth rate. If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell new shares.