Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionII. Financial Statements
and Long−Term Financial
Planning- Long−Term Financial
Planning and Growth
(^144) © The McGraw−Hill
Companies, 2002
This is identical to the internal growth rate except that ROE, return on equity, is used in-
stead 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:
Sustainable growth rate
21.36%
Thus, the Hoffman Company can expand at a maximum rate of 21.36 percent per year
without external equity financing..264 (2/3)
1 .264 (2/3)
ROE b
1 ROE bCHAPTER 4 Long-Term Financial Planning and Growth 113Sustainable 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.EXAMPLE 4.2HOFFMAN COMPANY
Pro Forma Income Statement
Sales (projected) $606.8
Costs (80% of sales) 485.4
Taxable income $121.4
Taxes (34%) 41.3
Net income $ 80.1
Dividends $26.7
Addition to retained earnings 53.4HOFFMAN COMPANY
Pro Forma Balance Sheet
Percentage Percentage
$ of Sales $ of Sales
Assets Liabilities and Owners’ Equity
Current assets $242.7 40% Total debt $250.0 n/a
Net fixed assets 364.1 60 Owners’ equity 303.4 n/a
Total assets $606.8 100% Total liabilities and owners’ equity $553.4 n/a
External financing needed $ 53.4 n/a