Fall 2015

EMSE 6430
Finance for Engineers

Managing Growth
September 23, 2015

Todays Goals

The sustainable growth equation

Balanced growth
What to do when actual growth exceeds
sustainable growth

The problem of too little growth and what to do

Sell new equity

Increase leverage
Reduce the payout ratio
Profitable pruning
Outsourcing
Pricing
Ignore the problem
Return money to shareholders
Buy growth

Homework 4

Chapter 4 4, 6, 7, 9
Due 09/30/2015
Finance for Engineers

Growth

Not Always a Blessing

Executives see growth as something to be

maximized

As growth increases, market share and profits should

rise

From a financial perspective, growth is not

always a blessing

Rapid growth can put considerable strain on a firms

resources
Firms can
literally
broke!growth
A better
path:grow
sustainable
Can lead to bankruptcy

Slow growth can also be a concern

Sustainable growth rate is the maximum rate at

Finance for Engineers

A Firms Life Cycle

Four Typical Phases

Start-up

Loses money,
while establishing
a foothold

Rapid growth

Profitable, but
needs infusion of
outside financing

Maturity

Declining growth, but

generating more cash
than it can invest
profitably

Decline

At best, marginally
profitable
Generating more cash
than investing
internally

Phases of the Technology Life-cycle

The research and development (R&D) phase

(sometimes called the "bleeding edge") when
incomes from inputs are negative and where the
prospects of failure are high
The ascent phase when initial costs have been
recovered and the technology begins to gather
strength (sometimes called the "leading edge")

The maturity phase when gain is high and

stable, the region, going into saturation,
and

The decline (or decay phase) of reducing

fortunes and utility of the technology
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Business
Benefit

Equity Life-cycle

Tim
e
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Equation
Underlying Logic

The firm wants to grow as rapidly as

market conditions permit

Assumptions:

Management is unwilling or unable to sell new

equity

The firm has a target capital structure and a

target dividend policy that it wants to
maintain

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Assets
Financed

Which Must Be

Assets = Liabilities +
Equity

More inventory, A.R., Machinery,

etc.

Sustainable Growth

The Equations

Change in equity
g*
Equitybop

Growth rate in
equity

Management is unwilling or unable to sell new equity

thus, the only source of new equity will be from
retained profits,

R Earnings
g*
Equitybop
R ROEbop
PRAT
RT ROA

$ from retained
earnings, where R
(retention rate) = (1
dividend rate, d)

Growth Rate Equation

What Are We Looking At?

P and A summarize operating performance

R and T describe the firms principal financial
policies

R captures managements attitudes towards the

distribution of dividends
T reflects its policies regarding financial leverage
If rate growth = g*, then one or
more of the ratios must change

If growth exceeds the sustainable growth rate,

Improve operations by increasing the profit margin or

asset turnover ratio, or
Alter financial policies by increasing retention rate or its
financial leverage Finance for Engineers

Too Much Growth

Heres the Problem

Increasing operating efficiency is not always

possible
Altering financial policy is not always wise
Small companies tend to see sales growth as
something to be maximized without
considering the financial consequences

Rapid growth implies more need for cash which is

met by increasing leverage
Eventually reach their debt capacity

Lenders refuse to give additional credits

May lead to inability to pay their bills

Management must anticipate any disparity between

actual growth and sustainable growth rate and have
a plan in place to manage the disparity
Finance for Engineers

Altering Financial Policy

Growth rate in sales (%)

Firm

Rapid Growth Vs. Mature

60
50
40
30
20
10
0
0

10

15

20

25

Return on assets (%)

30

35

40

Unbalanced Growth
A company with unbalanced growth
has three choices:

1.

Change its growth rate

2.

Change its ROA

3.

Change its financial policy, meaning the

slope of the line

Lets look at Medifest, Inc. and compare

their actual growth rates to their g*estimates

Finance for Engineers

A Sustainable Growth Analysis of

Medifast, Inc., 2006 2010

Respond to Gap

45% average growth in actual sales over

period; double sustainable growth rate

R close to or at 100%

P quite stable

A rose dramatically at end of period!

T stable

Finance for Engineers

Medifasts Sustainable Growth

Challenges, 2006-2010

16

A Sustainable Growth Analysis of

Medifast Inc., 20062010

What if?
Lets come back to some What If
questions

g* can be raised to 35.5% by increasing profit

margin to 8.2%
g* can be raised to 34.3% by raising financial
leverage to 1.8 times
Doing both will raise g* to 39.1%

What To Do When Actual Growth

Exceeds Sustainable Growth?

If growth rate is likely to decline in the near

future as firm reaches maturity

The firm may just borrow and wait for its growth to slow
down

When actual growth falls below sustainable growth in

future, the firm switches from a cash absorber to a cash
generator

Otherwise, then there is a laundry list

Sell new equity

Increase financial leverage
Reduce dividend payout
Prune marginal activities
Increase prices
Merge with a cash cow
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Sell New Equity

As A Strategy

If firm is willing and able to raise new equity,

excessive growth problems vanish

New equity plus added borrowing become sources of

cash to finance further growth

However, strategy may be difficult

May be too expensive

Market must be sufficiently developed

5 to 10% of amount required

Even higher rates for small issues
For right share price

Dilutes EPS
Most firms prefer not to raise equity
Finance for Engineers

Increase Leverage

Increasing leverage raises the amount of debt

the company can add for each dollar of retained
earnings
May be called the default option
Occurs naturally when management does not
plan ahead
As account payables rise by default
Creditors may eventually balk at raising debt
levels and force the company into default

The first step on the path to bankruptcy!

Finance for Engineers

Sources of Capital to U. S.
Nonfinancial
Corporations, 2001 - 2010

Reduce the Payout Ratio

Saves cash that can be used to build up equity

Can anger shareholders who respond by
selling their stock, thereby driving down stock
price
There also exists a lower limit of zero to a
companys dividend payments
Over half of 10,000 firms on S&Ps Compusat
data service paid no dividends in 2010
Owners interest in dividend payments varies
inversely with their perceptions of the
companys investment opportunities

Productive use of dividends in retained profits tends

to favor future dividends
Some Google shareholders
Finance for Engineershave complained about

Profitable Pruning

Risk reduction by diversification ensures that market

variability evens out in a conglomeration strategy
Two caveats:

Profitable pruning recognizes that a firm may spread its

resources too thin across many different markets/products
affecting its ability to compete

It does nothing for the shareholders who may choose their

diversification strategies independently
It weakens the firms ability to compete in a large number of
product markets

Better to sell off marginal operations and put the money back
into key business or operations

Helps to reduce sustainable growth problems in two ways:

Raises ROE, and 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?
Finance for Engineers

Outsourcing, Pricing,
Merger

Outsourcing increases asset turnover and

therefore ROA

Pricing increases ROE, if %-demand doesnt fall

by more than the %-price increase

It is imperative to know the firms core competencies

Activities that are deemed non core competencies may
be outsourced

Inverse relationship between price and volume

Raise price to reduce sales and thus reduce growth
Higher prices may increase the profit margin which in
turn improves the sustainable growth rate raising
prices is a very effective way to curb growth

Merger finds a cash cow (white knight, if

threatened) with deep pockets

for Engineers
Acquiring or beingFinance
acquired
addresses growth problems

Too Little Growth

What to do with the profits?

Slow growth firms have g*>actual growth

They have more cash than they know what to do with it

Examine Jos. A. Bank Clothiers, Inc.

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What Did Jos. A. Bank

Do?

Used the excess liquidity to reduce financial leverage

Reduced asset turnover

Jos. A. Bank sat on the money!

What do you see about clustering of growth rates and
returns?
What do you think the company should be thinking about
next?

Finance for Engineers

What To Do When Sustainable

Growth Exceeds Actual Growth?

Ask if situation is temporary

If yes, build up cash

If no, ask if phenomenon is industrywide, or within the firm

If within the firm, look for new product

lines, improvements, etc.

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Ignore the Problem?

Accumulate cash and slow growth

attracts corporate raiders
Why?
What do raiders believe?

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Return The Money To The

Shareholders

Increase dividends
Repurchase shares
Temptation is to invest in assets that
reduce corporate value but increase
managements empire

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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

Inflation

Inflation increases the nominal value of

assets such as accounts receivable,
inventory, and fixed assets (with a lag)

These still need to be financed, and the

problem is acute if prices are difficult to
raise quickly

The issue is important if banks miss the

connection

Finance for Engineers

New Equity Financing

The next slide illustrates the value of new

equity issues over time
What happened before and after 1983?
What happened in 2007?
What happened in 2008?
How does acquisition impact common
stock ownership?

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Net New Equity Issues 1975 - 2010

Acquisitions

In the last slide, what happened in 1998?

Companies reduce their shares by repurchasing

them or by acquiring the stock of another firm for
cash or debt

Was the situation different in the U.K. and Japan?

The numbers suggest that companies sell new

shares about once every 20 years

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Gross Proceeds

The 30 year average = $98.3b

High $234b in 2009
Spike at end from banks who were frantically
raising new equity to survive
Gross proceeds from new stock for
nonfinancial corporations equaled 4% of total
sources of capital
Relative to external sources, the number was
11.6%

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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
IPOs trendedGross
downward,
concern
to many
New StockaIssues
by Corporations
and Initial Public Offerings, 1980 - 2010

Companies Issue More

Equity?

Other sources generated sufficient cash

Equity is expensive to issue

Fear of diluting EPS in the short-run

Concern that their stock is undervalued in

the market

Windows close

Finance for Engineers

Financial Distress
And Its Consequences

Causes of business failure

Economic factors, e.g.,

Financial factors

Industry weakness
Poor locations
Too much debt
Insufficient capital

Other

Natural disaster
Fraud

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Consequences
Informal
reorganization
Informal
liquidation
Bankruptcy