Brealey, Myers. Principles of Corporate Finance. 7th edition
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
How Profitable Is Executive Paper?
Net Profit Margin If you want to know the proportion of sales that finds its
way into profits, you look at the profit margin. Thus
10
Return on Assets (ROA) Managers often measure the performance of the firm by
the ratio of income to total assets (income is usually defined as earnings before in-
terest but after taxes). This is known as the firm’s return on assets (ROA) or return
on investment (ROI):
11
Another measure focuses on the return on the firm’s equity:
Executive Paper’s return on assets and equity is in sharp contrast to the rest of the
industry, which provided a negative return in 1999.
It is natural to compare the return earned by Executive Paper with the opportu-
nity cost of capital. Of course, the assets in the financial statements are shown at net
book value, that is, original cost less depreciation.
12
So a low ROA does not necessar-
74.5
1509.3 5402/2
.142, or 14.2%
Return on equity 1ROE2
1earnings available for common stockholders2
average equity
1166.7 49.72
11, 380.8 1, 4502/2
.083,
or 8.3%
Return on assets
1EBIT tax2
1average total assets2
Net profit margin
1EBIT tax2
sales
.053,
or 5.3%
828 PART IX
Financial Planning and Short-Term Management
10
Net profit margin is sometimes measured as net . This ignores the profits that are paid out
to debtholders as interest and should therefore not be used to compare firms with different capital structures.
When making comparisons between firms, it makes sense to recognize that firms which pay more
interest pay less tax. We suggest that you calculate the tax that the company would pay if it were all-
equity-financed. To do this you need to adjust taxes by adding back interest tax shields (interest
tax rate). Using an assumed tax rate of 40 percent,
11
When comparing the returns on total assets of firms with different capital structures, it makes sense
to add back interest tax shields to tax payments (see footnote 10). This adjusted ratio then measures the
returns that the company would have earned if it were all-equity-financed.
One other point about return on assets. Since profits are a flow figure and assets are a snapshot fig-
ure, analysts commonly divide profits by the average of assets at the start and end of the year. The rea-
son that they do this is that the firm may raise large amounts of new capital during the year and then
put it to work. Therefore part of the year’s earnings is a return on this new capital.
However, this measure is potentially misleading and should not be compared closely with the
cost of capital. After all, when we defined the return that shareholders require from investing in the
capital market, we divided expected profit by the initial outlay, not by an average of starting and
ending values.
12
More careful comparisons between the return on assets and the cost of capital need to recognize the
biases in accounting numbers. We discussed these biases in Chapter 12.
166.7 349.7 1.4 42.5 24
2,200
0.45, or 4.5%
Net profit margin
EBIT 1tax interest tax shields2
sales
payments marginal
income sales
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
ily imply that those assets could be better employed elsewhere. Nor would a high
ROA necessarily mean that you could buy similar assets today and get a high return.
In a competitive industry, firms can expect to earn only their cost of capital. There-
fore, managers whose businesses are earning more than the cost of capital are likely
to earn a pat on the back, while those that are earning a low return may face some
tough questions or worse. Although shareholders like to see their companies earn a
high return on assets, consumers’ groups or regulators often regard a high return as
evidence that the firm is charging excessive prices. Naturally, such conclusions are
seldom cut and dried. There is plenty of room for argument as to whether the return
on assets is properly measured or whether it exceeds the cost of capital.
Payout Ratio The payout ratio measures the proportion of earnings that is paid
out as dividends. Thus
We saw in Section 16.2 that managers don’t like to cut dividends if there is a short-
fall in earnings. Therefore, if a company’s earnings are particularly variable, man-
agement is likely to play it safe by setting a low average payout ratio. When earn-
ings fall unexpectedly, the payout ratio will rise temporarily. Likewise, if earnings
are expected to rise next year, management may feel that it can pay somewhat more
generous dividends than it would otherwise have done.
How Highly Is Executive Paper Valued by Investors?
There is no law that prohibits you from introducing data that are not in the com-
pany accounts. For example, when you are assessing Executive Paper’s efficiency,
you might wish to look at the cost per ton of paper produced. Similarly, an airline
might calculate revenues per passenger mile flown, and so on. If you want to gauge
how highly Executive Paper is valued by investors, then you will need to calculate
ratios that combine accounting and stock market data. Here are three examples.
Price–Earnings Ratio The price–earnings, or P/E, ratio measures the price that in-
vestors are prepared to pay for each dollar of earnings. In the case of Executive Paper
In Section 4.4 we explained that a high P/E ratio may indicate that investors think the
firm has good growth opportunities or that its earnings are relatively safe and there-
fore more valuable. Of course, it may also mean that earnings are temporarily de-
pressed. If a company just breaks even with zero earnings, its P/E ratio is infinite.
Dividend Yield Executive’s dividend yield is simply its dividend as a proportion
of the stock price. Thus
Remember that the return to an investor comes in two forms—dividend yield and
capital appreciation. Executive Paper’s relatively high dividend yield may indicate
Dividend yield
dividend per share
stock price
3.09
50
.062, or 6.2%
P/E ratio
stock price
earnings per share
50
5.26
9.5
Payout ratio
dividends
earnings
43.8
74.5
.6
CHAPTER 29
Financial Analysis and Planning 829
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
that investors are demanding a relatively high rate of return or that they are not ex-
pecting rapid dividend growth with consequent capital gains.
Market-to-Book Ratio The market-to-book ratio is the ratio of the stock price to
book value per share. For Executive Paper
Book value per share is just stockholders’ book equity divided by the number of
shares outstanding. Book equity equals common stock plus retained earnings—the
net amount that the firm has received from stockholders or reinvested on their be-
half.
13
Thus Executive Paper’s market-to-book ratio of 1.3 means that the firm is
worth 30 percent more than past and present stockholders have put into it.
The Dupont System
Some of the profitability and efficiency ratios that we described above can be
linked in useful ways. These relationships are often referred to as the Dupont sys-
tem, in recognition of the chemical company that popularized them.
The first relationship links the return on assets (ROA) with the firm’s sales-to-
assets ratio and its profit margin:
ROA
EBIT tax
sales
EBIT tax
assets assets sales
↑↑
sales-to- profit
assets ratio margin
All firms would like to earn a higher return on assets but their ability to do so is
limited by competition. If the expected return on assets is fixed by competition,
firms face a trade-off between the sales-to-assets ratio and the profit margin. For
example, fast-food chains, which turn over their capital frequently, also tend to op-
erate on low profit margins. Classy hotels have relatively high margins, but this is
offset by lower sales-to-assets ratios.
Firms often seek to increase their profit margins by becoming more vertically in-
tegrated; for example, they may acquire a supplier or one of their sales outlets. Un-
fortunately, unless they have some special skill in running these new businesses,
they are likely to find that any gain in profit margin is offset by a decline in the
sales-to-assets ratio.
The return on equity (ROE) can be broken down as follows:
↑↑ ↑ ↑
leverage sales-to- profit “debt
ratio assets margin burden”
ratio
assets
equity
sales
assets
EBIT tax
sales
EBIT tax interest
1EBIT tax2
ROE
EBIT tax interest
equity
Market-to-book ratio
stock price
book value per share
50
540/14.16
1.3
830 PART IX Financial Planning and Short-Term Management
13
Retained earnings are measured net of depreciation. They represent stockholders’ new investment in
the business over and above the amount needed to maintain the firm’s existing stock of assets.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
Notice that the product of the two middle terms is the return on assets. This de-
pends on the firm’s production and marketing skills and is unaffected by the fi-
nancing mix. However, the first and fourth terms do depend on the debt–equity
mix.
14
The first term measures the ratio of gross assets to equity, while the last term
measures the extent to which profits are reduced by interest. If the firm is lever-
aged, the first term is greater than 1.0 (assets are greater than equity) and the fourth
term is less than 1.0 (part of the profits are absorbed by interest). Thus, leverage can
either increase or reduce the return on equity. In the case of Executive Paper
So, for Executive Paper the leverage ratio (2.70) more than offsets the debt burden
(.637). Executive’s leverage increases its return on equity.
2.70 1.55 .053 .637 .14
ROE leverage ratio sales-to-assets ratio profit margin debt burden
CHAPTER 29
Financial Analysis and Planning 831
14
There is a complication here because the amount of tax paid does depend on the financing mix. We
suggested in footnote 10 that it would be better to add back any interest tax shields to the tax payment
when calculating the firm’s profit margin.
15
The Blitzen Computers example in Section 22.1 illustrates how option theory can be used to quantify
a project’s strategic value.
29.4 FINANCIAL PLANNING
Executive Paper’s financial statements not only help you to understand the past, but
they also provide the starting point for developing a financial plan for the future.
Financial plans begin with the firm’s product development and sales objectives.
For example, Executive Paper’s corporate staff might ask each division to submit
three alternative business plans covering the next five years:
1. A best-case or aggressive growth plan calling for heavy capital investment,
new products, and an increased market share.
2. A normal growth plan in which the division grows with its markets but not
at the expense of its competitors.
3. A plan of retrenchment designed to minimize capital outlays. This is
planning for lean economic times.
Of course, the planners might also look at the opportunities for moving into a
wholly new area where the company can exploit its existing strengths. Often they
may recommend entering the market for strategic reasons, that is, not because the
immediate investment is profitable but because it establishes the firm in the market
and creates options for possibly valuable follow-on investments. In other words,
there is a two-stage decision. At the second stage (the follow-on project) the finan-
cial manager faces a standard capital budgeting problem. But at the first stage proj-
ects may be valuable primarily for the options they bring with them.
15
To see the financial consequences of the business plan, you need to develop fore-
casts of future cash flows. If the likely operating cash flow is insufficient to cover
both the planned dividend payments and the investment in net working capital
and fixed assets, then the firm needs to ensure that it can raise the balance by bor-
rowing or by the sale of additional shares.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
Cash-flow forecasts should always be subjected to a reality check. For exam-
ple, few companies can expect to continue to earn a high return on their invest-
ment without attracting competition. So firms are likely to find it difficult to
maintain a high return on assets indefinitely. Conversely, those with a low return
on assets may hope for some easing of competitive pressures and the arrival of
more normal returns.
16
When you prepare a financial plan, you shouldn’t look just at the most likely fi-
nancial consequences. You also need to plan for the unexpected. One way to do this
is to work through the consequences of the plan under the most likely set of circum-
stances and then use sensitivity analysis to vary the assumptions one at a time. An-
other approach is to look at the implications of different plausible scenarios.
17
For ex-
ample, one scenario might envisage high interest rates leading to a slowdown in
world economic growth and lower commodity prices. The second scenario might in-
volve a buoyant domestic economy, high inflation, and a weak currency.
832 PART IX
Financial Planning and Short-Term Management
16
For evidence that accounting returns tend to regress toward the mean, see Chapter 10 of K. G. Palepu,
P. M. Healy, and V. L. Bernard, Business Analysis and Valuation, South-Western College Publishing,
Cincinnati, OH, 2nd ed., 2000.
17
For a description of the use of different planning scenarios in the Royal Dutch/Shell group, see
P. Wack, “Scenarios: Uncharted Waters Ahead,” Harvard Business Review 63 (September–October 1985)
and “Scenarios: Shooting the Rapids,” Harvard Business Review 64 (November–December 1985).
29.5 FINANCIAL PLANNING MODELS
Suppose that management has asked you to assume a 20 percent annual growth in
Executive Paper’s sales and profits over the next five years. Can the company re-
alistically expect to finance this out of retained earnings and borrowing, or should
it plan for an issue of equity? Spreadsheet programs are tailor-made for such ques-
tions. Let’s investigate.
The basic sources and uses relationship tells us that
Thus there are four steps to finding how much extra cash Executive Paper will
need and the implications for its debt ratio:
Step 1 Project next year’s operating cash flow (depreciation provision plus net
income) assuming the planned 20 percent increase in revenues. This gives the to-
tal sources of funds in the absence of any new issue of securities. Look, for exam-
ple, at the second column of Table 29.6, which provides a forecast of operating cash
flow in year 2000 for Executive Paper.
Step 2 Project what additional investment in net working capital and fixed assets
will be needed to support this increased activity and how much of the net income
will be paid out as dividends. The sum of these expenditures gives you the total
dividends
investment in fixed assets
investment in net working capital
operating cash flow
External capital required
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
uses of funds. The second column of Table 29.7 provides a forecast of uses of funds
for Executive Paper.
Step 3 Calculate the difference between the projected operating cash flow (from
Step 1) and the projected uses (Step 2). This is the cash that will need to be raised
from new sales of securities. For example, you can see from Table 29.7 that Execu-
tive Paper will need to issue $158.6 million of debt in 2000 if it is to expand at the
planned rate and not sell more shares.
Step 4 Finally, construct a pro forma balance sheet that incorporates the addi-
tional assets and the increase in debt and equity. This is done in the second col-
umn of Table 29.8. Executive Paper’s equity increases by the additional retained
earnings (net income less dividends), while long-term debt is increased by the
$158.6 million new issue.
Once you have set up the spreadsheet, it is easy to run out your projections for
several years. The final columns in Tables 29.6–29.8 show the pro forma income
statement, sources and uses of funds, and balance sheet for the year 2004, assum-
ing Executive Paper continues to fund a 20 percent annual growth rate solely from
retained earnings and new debt issues. Over the five-year period Executive Paper
would need to borrow an additional $1.2 billion and by year 2004 its debt ratio
would have increased to 67 percent. Most financial managers would regard this as
sailing much too close to the wind, and the debt ratio would probably be above the
limit set by the company’s banks and bondholders.
CHAPTER 29
Financial Analysis and Planning 833
1999 2000 2004
Revenues 2,200 2,640 5,474
Costs (90% of revenues) 1,980 2,376 4,927
Depreciation (10% of fixed assets at start of year) 53.3 55.0 114
EBIT 166.7 209.0 433.4
Interest (10% of long-term debt at start of year) 42.5 45 131.3
Tax (40% of pretax profit) 49.7 65.6 120.8
Net income 74.5 98.4 181.2
Operating cash flow 127.8 153.4 295.3
TABLE 29.6
Latest and pro forma
income statements
for Executive Paper
(figures in $ millions).
1999 2000 2004
Increase in net working capital (NWC) assuming NWC 20% of revenues 38.5 88 182.5
Investment in fixed assets (FA) assuming FA 25% of revenues 70.2 165 342.1
Dividend (60% of net income) 45.6 59.0 108.7
Total uses of funds 129.3 312.0 633.4
External capital required total uses of funds operating cash flow 25.0 158.6 338.1
TABLE 29.7
Latest and pro forma statements of sources and uses of funds for Executive Paper (figures in $ millions).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
The obvious solution for Executive Paper is to issue a mix of debt and equity, but
there are other possibilities that the financial manager may want to explore. One
option may be to hold back dividends during this period of rapid growth, but it
turns out that even a complete dividend freeze would still leave Executive Paper
needing to raise just under $750 million of new funds. An alternative might be to
investigate whether the company could cut back on net working capital. For ex-
ample, we have seen that Executive Paper’s customers take 72 days to pay their
bills. Perhaps more careful control of credit collection could help to economize on
capital.
We stated earlier that financial planning is not just about exploring how to cope
with the most likely outcomes. It also needs to ensure that the firm is prepared for
unlikely ones. For example, the paper industry is notoriously exposed to economic
downturn. So you would certainly wish to check that Executive Paper could cope
with a cyclical decline in sales and profit margins. Sensitivity analysis or scenario
analysis can help you to do so.
Executive Paper’s problem is not unique, for many companies find that rapid
growth can bring burgeoning debt levels. Firms that fail to think through the fi-
nancial consequences of their growth plans are liable to get into BIG trouble. Look,
for example, at the Finance in the News box, which shows how British Telecom’s
attempt to become a global telecom company forced some hard thinking about
how to finance this growth.
Pitfalls in Model Design
The Executive Paper model that we have developed is too simple for practical ap-
plication. You probably have already thought of several ways to improve it—by
keeping track of the outstanding shares, for example, and printing out earnings
and dividends per share. Or you might want to distinguish between short-term
lending and borrowing opportunities, now buried in working capital.
The model that we developed for Executive Paper is known as a percentage of
sales model. Almost all the forecasts for the company are proportional to the fore-
casted level of sales. However, in reality many variables will not be proportional to
sales. For example, important components of working capital such as inventory
and cash balances will generally rise less rapidly than sales. In addition, fixed as-
sets such as plant and equipment are typically not added in small increments as
sales increase. Executive Paper’s plant may well be operating at less than full ca-
pacity, so that the company can initially increase output without any additions to
capacity. Eventually, however, if sales continue to increase, the firm may need to
make a large new investment in plant and equipment.
834 PART IX
Financial Planning and Short-Term Management
1999 2000 2004
Net working capital (20% of revenues) 440 528 1,095
Net fixed assets (25% of revenues) 550 660 1,369
Total net assets 990 1,188 2,463
Long-term debt 450 608.6 1,651
Equity 540 579.4 812
Total long-term liabilities and equity 990 1,188 2,463
TABLE 29.8
Latest and pro forma balance
sheets for Executive Paper
(figures in $ millions).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
But beware of adding too much complexity: There is always the temptation to
make a model bigger and more detailed. You may end up with an exhaustive
model that is too cumbersome for routine use. The fascination of detail, if you
give in to it, distracts attention from crucial decisions like stock issues and divi-
dend policy.
There Is No Finance in Financial Planning Models
Why do we say there is no finance in these corporate financial models? The first
reason is that they usually incorporate an accountant’s view of the world. They
are designed to forecast accounting statements. They do not emphasize the
tools of financial analysis: incremental cash flow, present value, market risk,
and so on.
18
This may not matter as long as everyone recognizes the financial forecasts for
what they are. However, you sometimes hear managers stating corporate goals
in terms of accounting numbers. They may say, “Our objective is to achieve an
835
FINANCE IN THE NEWS
INVESTORS QUESTION BRITISH TELECOM’S
FINANCIAL PLANNING
As the country’s principal telecom supplier, British
Telecom (BT) was a safe, if somewhat uninspiring,
investment. Including short-term loans, its debt ra-
tio was a fairly conservative .38 and the volatility of
its stock returns was well below the average for UK
companies.
All that changed at the end of the 1990s when
BT made a series of foreign acquisitions and paid
several billion pounds for a license to offer third-
generation mobile services in the UK. These expen-
ditures were financed largely by new borrowing, in-
cluding a record $10 billion bond issue in the United
States. By December 2000 BT’s debt had expanded
to £30 billion and the debt ratio had climbed to .71.
To reassure new bondholders BT had agreed that, if
its debt rating were subsequently lowered, it would
increase the interest payment on its bonds. Not long
afterward the rating agencies announced that they
were considering a downgrade, which would in-
crease the cost of servicing BT’s debt.
BT’s aim was to reduce its debt by £10 billion,
and it hoped to achieve this by selling off some re-
cent acquisitions. Unfortunately, as the prices of
high-tech stocks fell away in the spring of 2001, this
plan began to look less and less attractive.
By March 2001 BT’s share price had fallen 70
percent from its high, and anxious investors be-
gan to question whether the company had a co-
herent strategy to deal with its mountain of debt
and to finance the heavy expenditures that would
be needed to exploit its mobile licenses. Various
questions were asked and debated. Should the
company press ahead with its plans to sell off
businesses? Could it live with its high debt ratio
for the time being? Should it seek to build up eq-
uity by cutting its dividend or by issuing new eq-
uity? It was clear that for BT, financial planning
had become central to the company’s survival.
18
Of course, there is no reason that the manager can’t use the output to calculate the present value of the
firm (given some assumption about growth beyond the planning period), and this is sometimes done.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
annual sales growth of 20 percent,” or “We want a 25 percent return on book eq-
uity and a profit margin of 10 percent.” On the surface such objectives don’t
make sense. Shareholders want to be richer, not to have the satisfaction of a
10 percent profit margin. Also, a goal that is stated in terms of accounting ratios
is not operational unless it is translated back into what the statement means for
business decisions. For example, what does a 10 percent profit margin imply—
higher prices, lower costs, increased vertical integration, or a move into new,
high-margin products?
So why do managers define objectives in this way? In part such goals may be a
mutual exhortation to try harder, like singing the company song before work. But
we suspect that managers are often using a code to communicate real concerns. For
example, the goal to increase sales rapidly may reflect managers’ belief that in-
creased market share is needed to achieve scale economies, or a target profit mar-
gin may be a way of saying that the firm has been pursuing sales growth at the ex-
pense of margins. The danger is that everyone may forget the code and the
accounting targets may be seen as goals in themselves.
The second reason for saying that there is no finance in these planning models
is that they produce no signposts pointing toward optimal decisions. They do not
even tell us which alternatives are worth examining. For example, we saw that Ex-
ecutive Paper is planning for a rapid growth in sales and earnings per share. But is
that good news for the shareholders? Well, not necessarily; it depends on the op-
portunity cost of the capital that Executive Paper needs to invest. If the new in-
vestment earns more than the cost of capital, it will have a positive NPV and add
to shareholder wealth. However, the return that Executive Paper is forecasting to
earn on its new investment is little more than the interest rate on its debt and al-
most certainly below Executive’s cost of capital. In this case the company’s planned
investment will make shareholders worse off, even though the company expects
steady growth in earnings per share.
The capital that Executive Paper needs to raise depends on its decision to pay
out two-thirds of its earnings as a dividend. But the financial planning model
does not tell us whether this dividend payment makes sense or what mixture of
equity or debt the company should issue. In the end the management has to de-
cide. We would like to tell you exactly how to make the choice, but we can’t.
There is no model that encompasses all the complexities encountered in financial
planning.
As a matter of fact, there never will be one. This bold statement is based on
Brealey and Myers’s Third Law:
19
• Axiom: The number of unsolved problems is infinite.
• Axiom: The number of unsolved problems that humans can hold in their
minds is at any time limited to 10.
• Law: Therefore in any field there will always be 10 problems which can be
addressed but which have no formal solution.
Brealey and Myers’s Third Law implies that no model can find the best of all fi-
nancial strategies.
20
836 PART IX Financial Planning and Short-Term Management
19
The second law is presented in Section 12.2.
20
It is possible to build linear programming models that help search for the best strategy subject to spec-
ified assumptions and constraints. These models can be more effective in screening alternative finan-
cial strategies.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
IX. Financial Planning and
Short−Term Management
29. Financial Analysis and
Planning
© The McGraw−Hill
Companies, 2003
We started this chapter by noting that financial plans force managers to be consis-
tent in their goals for growth, investment, and financing. Before leaving the topic
of financial planning, we should look at some general relationships between a
firm’s growth objectives and its financing needs.
Recall that Executive Paper ended 1999 with fixed assets and net working cap-
ital of $990 million. In 2000 it plans to plow back $39.4 million, so net assets will
increase by 39.4/990 or 3.98 percent. Thus Executive Paper can grow by 3.98 per-
cent without needing to raise additional capital. The growth rate that a company
can achieve without external funds is known as the internal growth rate. For Ex-
ecutive Paper
We can gain more insight into what determines this growth rate by multiplying the
top and bottom of the expression for internal growth rate by net income and equity
as follows:
In 2000 Executive Paper expects to plow back 40 percent of net income and to
earn a return of 18.22 percent on the equity with which it began the year. At the
start of the year equity finances 54.55 percent of Executive Paper’s net assets.
Therefore
Notice that if Executive Paper wishes to grow faster than this without raising
equity capital, it would need to (1) plow back a higher proportion of its earn-
ings, (2) earn a higher return on equity (ROE), or (3) have a lower debt-to-equity
ratio.
21
Instead of focusing on how rapidly the company can grow without any external
financing, Executive Paper’s financial manager may be interested in the growth
rate that can be sustained without additional equity issues. Of course, if the firm is
able to raise enough debt, virtually any growth rate can be financed. It makes more
sense to assume that the firm has settled on an optimal capital structure which it
will maintain as equity is increased by the retained earnings. Thus the firm issues
only enough debt to keep the debt–equity ratio constant. The sustainable growth rate
is the highest growth rate the firm can maintain without increasing its financial
leverage. It turns out that the sustainable growth rate depends only on the plow-
back rate and the return on equity:
Sustainable growth rate plowback ratio return on equity
Internal growth rate .40 .1822 .5455 .0398,
or 3.98%
plowback ratio return on equity
equity
net assets
Internal growth rate
retained earnings
net income
net income
equity
equity
net assets
Internal growth rate
retained earnings
net assets
3.98%
CHAPTER 29
Financial Analysis and Planning 837
29.6 GROWTH AND EXTERNAL FINANCING
21
Notice that the internal growth rate does not stay constant. As the firm plows back earnings, the debt-
to-equity ratio declines and the internal growth rate increases.