Introduction to Corporate Finance

(avery) #1
Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

II. Financial Statements
and Long−Term Financial
Planning


  1. 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 b

CHAPTER 4 Long-Term Financial Planning and Growth 113

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.

EXAMPLE 4.2

HOFFMAN 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 53.4

HOFFMAN 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
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