Slides_Higgins_12e_Ch_4.pptxManaging Growth
Chapter Four
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Higgins, Analysis for Financial Management, 12e
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1
Different Phases of the Life Cycle Pose Different Challenges
Consider a firm in its rapid growth phase.
Sales growth requires investment in AR, inventory, and productive capacity.
Consider a firm in its declining phase.
Often the cash produced isn’t required for further investment and must be used elsewhere.
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The Company Life Cycle
Startup (usually with losses)
Rapid growth (with infusions of outside financing)
Maturity (generating cash)
Decline (marginally profitable, with cash to search for new products, investments)
Ch. 4 3
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FIGURE 4.1 New Sales Require New Assets, Which Must Be Financed
Ch. 4 4
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Higgins, Analysis for Financial Management, 12e
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The Sustainable Growth Rate
A company’s sustainable growth rate is the maximum rate at which it can grow without depleting financial resources.
The sustainable growth rate is based on the assumption that management will not sell new equity and will maintain a constant debt ratio.
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Sustainable Growth Rate = g*
What limits the rate at which this company can increase sales or, more generally, its overall expansion?
From Figure 4.1, the limit to growth is the rate at which equity expands.
New equity→New debt→More assets→More sales
Therefore, g* is the ratio of the change in equity to equity at the beginning of the period.
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Equations for g*
Ch. 4 7
What’s the meaning of R?
Higgins, Analysis for Financial Management, 12e
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Ch. 3 8
You try it. Calculate the sustainable growth rate for 2017.
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g* = Change in equity/equitybop = (3126-2950)/2950 = 6.0%
g* = R × ROEbop = 0.6 × 293/2950 = 6.0% [R = (3126-2950)/293 = 0.6; assuming no new equity issued]
g* = PRAT = (293/5500) × 0.6 × (5500/4950) × (4950/2950) = 6.0%
8
Levers of Growth
The levers of growth here are PRAT.
g* is the only growth rate consistent with these ratios.
If a company grows at a rate g > g*, then one of the four levers must increase.
If a fast-growing company can’t increase profit margin, retention ratio, or asset turnover, it will end up increasing leverage.
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Balanced Growth
Here’s yet another formula for sustainable growth:
With this definition, g* is the combination of financial policy (R and T) and operating performance (ROA).
Balanced growth is a growth rate that can be self-financed for a given level of profitability (ROA), holding the firm’s financial policy (R and T) constant.
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FIGURE 4.2 A Graphical Representation of Sustainable Growth
Ch. 4 11
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Unbalanced Growth
A company with unbalanced growth has 3 choices:
Change its growth rate (g).
Change its ROA (P or A).
Change its financial policy, meaning the slope of the line (R or T).
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Too Much Growth
Growing companies often want to maximize growth.
But companies must plan for the financial consequences of high growth.
Without planning, companies can “grow broke”.
*The goal is not to have actual growth equal sustainable growth, but to understand and manage the consequences of any disparity between the two.
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TABLE 4.1 Sustainable Growth Analysis of Nobility Homes, 2012–2016
Ch. 4 14
How does Nobility’s g compare to its g*?
How is Nobility dealing with the gap between g and g*?
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Nobility Homes’ Response to the Gap
Over 25% average growth in actual sales over period; well over sustainable growth rate
P: Increase from 0.3% to 17.5%
R: maxed out at 100%
A: 52% increase
T: 25% increase
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FIGURE 4.3 Nobility Homes’ Sustainable Growth Challenges, 2012–2016
Ch. 4 16
Has Nobility resolved its cash deficits?
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Higgins, Analysis for Financial Management, 12e
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What To Do When Actual Growth Exceeds Sustainable Growth
If growth is temporarily too fast, just borrow and wait for it to slow down.
If not, then there are a number of possible actions to take.
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Option #1: Sell New Equity
Get cash
Increase borrowing capacity
Difficult to do in most countries
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TABLE 4.2 Sources of Capital to U.S. Nonfinancial Corporations, 2007–2016
Ch. 4 19
Do U.S. companies like to sell new equity?
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Option #2: Increase Leverage
Raises cash
Also raises risk of bankruptcy
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Option #3: Reduce the Payout Ratio
Saves cash that can be used to build up equity
Can disappoint shareholders who respond by selling their stock, thereby driving down stock price
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Option #4: Profitable Pruning
Raises ROE, and therefore earnings, and therefore retained earnings
Retained earnings are part of equity.
Prune by un-diversifying unrelated product lines with no synergy.
Who benefits from corporate diversification, shareholders or managers?
Un-diversifying generates cash from the sale of assets.
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Option #5: Outsourcing
Can increase asset turnover and therefore, ROA
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Option #6: Raise Prices
Increases ROE, if %-demand doesn’t fall by more than the %-price increase
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Option #7: Merger
Find a cash cow (white knight, if threatened) with deep pockets
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Too Little Growth
What to do with profits in excess of the needs of the company?
This may not sound like a difficult problem, but it must be managed wisely.
Ch. 4 26
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TABLE 4.3 Sustainable Growth Analysis of Hasbro, 2012–2016
Ch. 4 27
How does Hasbro’s g compare to its g*?
How is Hasbro dealing with the gap between g and g*?
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Higgins, Analysis for Financial Management, 12e
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27
What Did Hasbro Do?
Ch. 4 28
Sustainable growth rates higher than actual growth rates by a 3-to-1 ratio, on average
P: Increase
R: Increase (but also repurchased shares)
A: Slight increase
T: Fairly constant
How does the change in Hasbro’s growth rate help the situation?
Higgins, Analysis for Financial Management, 12e
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FIGURE 4.4 Hasbro’s Stryker’s Sustainable Growth Challenges, 2012–2016
Ch. 4 29
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Higgins, Analysis for Financial Management, 12e
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What To Do When Sustainable Growth Exceeds Actual Growth
Ask if the situation is temporary.
If yes, build up cash.
If no, ask if the phenomenon is industry-wide, or within the firm.
If within the firm, then a few options are available.
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Option #1: Ignore the Problem
Accumulated cash and slow growth attracts corporate raiders.
Why?
What do raiders believe?
Is a corporate raid bad news for shareholders?
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Option #2: Return The Money To The Shareholders
Increase dividends
Repurchase shares
Temptation is to invest in assets that reduce corporate value but increase management’s empire
Ch. 4 32
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Option #3: Buy Growth
Buy other businesses, especially ones that need cash because they are growing rapidly.
History suggests that returning the money is the better option.
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Sustainable Growth and Pro Forma Forecasts
Comparing actual growth and sustainable growth reveals a lot about management’s financial concerns.
When g>g*, focus is on getting cash for expansion
When g<g*, focus is on productively spending cash
Managers generally try to balance strategy, growth, and financial policy to make the disparity between g and g* manageable.
However, to really understand growth management challenges, pro formas should be prepared.
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New Equity Financing
As Table 4.2 showed, companies don’t issue a lot of new equity.
On average, companies repurchase more stock than they sell.
The next slide illustrates the value of new equity issues over time.
What happened in 1983? 2007? 2008?
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FIGURE 4.5 Net New Equity Issues 1980–2016
Ch. 4 36
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Share Repurchases
Much of the trend over time can be attributed to the increasing popularity of share repurchases.
Repurchases can help manage EPS.
Repurchases are viewed as more flexible than dividend payments.
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FIGURE 4.6 Gross New Stock Issues by Corporations and IPOs, 1980–2016
Ch. 4 38
What caused this peak?
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Gross Proceeds
Even though net new equity issues are typically negative, corporations are still issuing stock.
Average since 1980 = $71 billion per year
High of $295 billion in 2000
The gross proceeds from public equity issues for nonfinancial corporations equaled 3% of the total sources of capital over past decade.
The typical public company raises new equity in public markets once every 20 years.
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IPOs
Check the graph of IPOs relative to gross public equity issues.
Modest 25% of new equity raised over the period
In 2000, IPOs contributed 5% of total external capital.
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Why Don’t U.S. Companies Issue More Equity?
Other sources generated sufficient cash
Equity is expensive to issue
Perhaps 5% to 10% of amount raised
Higher percentage for smaller companies
Fear of diluting EPS in the short run
Concern that their stock is undervalued in the market
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2016201720162017
Sales$5,000$5,500Cash$250$275
COGS4,0004,400A/R750825
Operating expense500550Inventory1,5001,650
EBIT500550 Total current assets2,5002,750
Interest expense9399Net PP&E2,0002,200
EBT407451 Total assets4,5004,950
Tax142158
Net income$265$293Total debt1,5501,641
Shareholders' equity2,9503,126
Total liabilities & equity$4,500$4,767
S&S Corporation
Financial Statements ($ millions)
Income StatementBalance Sheet
S&S pro formas
| S&S Corporation | ||||||
| Financial Statements ($ millions) | ||||||
| Income Statement | Balance Sheet | |||||
| 2016 | 2017 | 2016 | 2017 | |||
| Sales | $5,000 | $5,500 | Cash | $250 | $275 | |
| COGS | 4,000 | 4,400 | A/R | 750 | 825 | |
| Operating expense | 500 | 550 | Inventory | 1,500 | 1,650 | |
| EBIT | 500 | 550 | Total current assets | 2,500 | 2,750 | |
| Interest expense | 93 | 99 | Net PP&E | 2,000 | 2,200 | |
| EBT | 407 | 451 | Total assets | 4,500 | 4,950 | |
| Tax | 142 | 158 | ||||
| Net income | $265 | $293 | Total debt | 1,550 | 1,641 | |
| Shareholders' equity | 2,950 | 3,126 | ||||
| Total liabilities & equity | $4,500 | $4,767 | ||||
| Assumptions | ||||||
| Sales growth rate | 10.0% | External funding required | ||||
| COGS/sales | 80.0% | Sustainable growth rate | ||||
| Retention ratio | 60.0% | |||||
| PP&E/sales | 40.0% | |||||
| Total debt/equity | 52.5% |
