Managing Growth CHAPTER 4 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction <ul><li>It is possible for companies to grow too quickly. </li></ul><ul><li>It is possible for companies to g...
Sustainable Growth <ul><li>A company’s sustainable growth rate is the maximum rate it can grow without depleting financial...
Phases <ul><li>Startup (usually with losses) </li></ul><ul><li>Rapid growth (with infusions of outside financing) </li></u...
The Sustainable Growth Equation <ul><li>Consider a situation when a company has a target dividend payout policy, target ca...
FIGURE 4-1 New Sales Require New Assets, Which Must Be Financed
g* <ul><li>What limits the rate at which this company can increase sales, or more generally its overall expansion? </li></...
Plowback <ul><li>If the firm pays out all of its earnings as dividends, it cannot grow equity. </li></ul><ul><li>If R stan...
Levers of Growth <ul><li>The levers of growth here are PRAT. </li></ul><ul><li>g* is the only sustainable growth rate cons...
Balanced Growth <ul><li>ROA is Net income / Assets. </li></ul><ul><li>With this definition, g* is the product of (RT) and ...
FIGURE 4-2 A Graphical Representation of Sustainable Growth
Unbalanced Growth <ul><li>A company with unbalanced growth has 3 choices: </li></ul><ul><li>Change its growth rate. </li><...
TABLE 4-1 A Sustainable Growth Analysis of Genentech, Inc., 2003 – 2007*
Respond to Gap <ul><li>Compare 2007 against prior years. </li></ul><ul><li>R stayed at 100%. </li></ul><ul><li>With some e...
FIGURE 4-3 Genentech’s Sustainable Growth Challenges, 2003-2007
What If? <ul><li>Let’s come back to some What If questions. </li></ul><ul><li>Check the bottom of the next slide. </li></ul>
TABLE 4-1 A Sustainable Growth Analysis of Genentech Inc., 2003 – 2007*
What To Do When Actual Growth Exceeds Sustainable Growth? <ul><li>If growth is temporarily too fast, just borrow and wait ...
Sell New Equity <ul><li>Get cash. </li></ul><ul><li>Increase borrowing capacity. </li></ul><ul><li>Difficult to do in most...
Increase Leverage <ul><li>Raises cash. </li></ul><ul><li>Also raises risk of bankruptcy. </li></ul>
Reduce the Payout Ratio <ul><li>Saves cash that can be used to build up equity. </li></ul><ul><li>Can anger shareholders w...
Profitable Pruning <ul><li>Raises ROE, and therefore earnings, and therefore retained earnings. </li></ul><ul><li>Retained...
Outsourcing <ul><li>Increase asset turnover and therefore ROA. </li></ul>
Pricing <ul><li>Increases ROE, if %-demand doesn’t fall by more than the %-price increase. </li></ul>
Merger <ul><li>Find a cash cow (white knight, if threatened) with deep pockets. </li></ul>
Too Little Growth <ul><li>What to do with the profits? </li></ul><ul><li>In a couple of slides, examine Table 4-3 (Scotts ...
TABLE 4-2 Sources of Capital to U. S. Nonfinancial  Corporations, 1998-2007
TABLE 4-3 A Sustainable Growth Analysis of Scotts Miracle-Gro Company, 2003-2007*
What Did Scotts Do? <ul><li>Paid dividends. </li></ul><ul><li>Reduced financial leverage. </li></ul><ul><li>Leveraged reca...
FIGURE 4-4 Scotts Miracle-Gro Company’s Sustainable Growth Challenges, 2003-2007
What To Do When Sustainable Growth Exceeds Actual Growth? <ul><li>Ask if situation is temporary. </li></ul><ul><li>If yes,...
Ignore the Problem? <ul><li>Accumulate cash and slow growth attracts corporate raiders. </li></ul><ul><li>Why? </li></ul><...
Return The Money To The Shareholders <ul><li>Increase dividends. </li></ul><ul><li>Repurchase shares. </li></ul><ul><li>Te...
Buy Growth <ul><li>Buy other businesses, especially ones that need cash because they are growing rapidly. </li></ul><ul><l...
Sustainable Growth and Inflation <ul><li>Inflation increases the nominal value of assets such as AR, inventory, and fixed ...
New Equity Financing <ul><li>The next slide illustrates the value of new equity issues over time. </li></ul><ul><li>What h...
FIGURE 4-5 Net New Equity Issues 1971-2007
FIGURE 4-5 (Continued) Sources.  Federal Reserve System, Flow of Funds Accounts of the United States,  http://www.federalr...
Acquisitions <ul><li>In the last slide, what happened in 1998? </li></ul><ul><li>Companies reduce their shares by repurcha...
Gross Proceeds <ul><li>Check the graph on the next slide. </li></ul><ul><li>Gross proceeds from new stock equaled 9% of to...
FIGURE 4-6 Gross Public Equity Issues and Initial  Public Offerings, 1970-2006
Note: New equity is publicly issued stock including preferred stock.  IPOs exclude over allotment options but include the ...
Why Don’t US Companies Issue More Equity? <ul><li>Other sources generated sufficient cash. </li></ul><ul><li>Equity is exp...
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Chap004

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Chap004

  1. 1. Managing Growth CHAPTER 4 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Introduction <ul><li>It is possible for companies to grow too quickly. </li></ul><ul><li>It is possible for companies to grow too slowly. </li></ul><ul><li>Growth needs to be managed. </li></ul>
  3. 3. Sustainable Growth <ul><li>A company’s sustainable growth rate is the maximum rate it can grow without depleting financial resources. </li></ul><ul><li>How to compute a company’s sustainable growth rate? </li></ul><ul><li>How to respond when growth veers off the sustainable trajectory? </li></ul>
  4. 4. Phases <ul><li>Startup (usually with losses) </li></ul><ul><li>Rapid growth (with infusions of outside financing) </li></ul><ul><li>Maturity (generating cash) </li></ul><ul><li>Decline (marginally profitable, with cash to search for new products, investments) </li></ul>
  5. 5. The Sustainable Growth Equation <ul><li>Consider a situation when a company has a target dividend payout policy, target capital structure, and does not wish to issue new shares or repurchase existing shares. </li></ul><ul><li>Consider a firm whose sales are growing rapidly. </li></ul><ul><li>Sales growth requires investment in AR, inventory, and productive capacity. </li></ul>
  6. 6. FIGURE 4-1 New Sales Require New Assets, Which Must Be Financed
  7. 7. g* <ul><li>What limits the rate at which this company can increase sales, or more generally its overall expansion? </li></ul><ul><li>From the previous figure, the limit to growth is the rate at which equity expands. </li></ul><ul><li>Therefore, g* is the ratio of the Change in equity to Equity at the beginning of the period. </li></ul>
  8. 8. Plowback <ul><li>If the firm pays out all of its earnings as dividends, it cannot grow equity. </li></ul><ul><li>If R stands for the plowback ratio, then g* is the product of R and Earnings over Equity. </li></ul><ul><li>g* = R x ROE. </li></ul><ul><li>g* = R x P x A x T or PRAT, </li></ul><ul><li>where T (T-hat) is Assets/Equity based on beginning of period Equity, A is asset turnover, and P is profit margin. </li></ul>
  9. 9. Levers of Growth <ul><li>The levers of growth here are PRAT. </li></ul><ul><li>g* is the only sustainable growth rate consistent with these ratios. </li></ul><ul><li>A company that grows too quickly might not be able to increase operating efficiency, and therefore resort to increased leverage. </li></ul><ul><li>Sometimes that is like playing Russian roulette. </li></ul>
  10. 10. Balanced Growth <ul><li>ROA is Net income / Assets. </li></ul><ul><li>With this definition, g* is the product of (RT) and ROA, where RT reflects financial policy and ROA reflects operating performance. </li></ul><ul><li>Look at Figure 4-2 in the next slide, where sales growth off the line with slope RT generate either cash deficits or surpluses. </li></ul>
  11. 11. FIGURE 4-2 A Graphical Representation of Sustainable Growth
  12. 12. Unbalanced Growth <ul><li>A company with unbalanced growth has 3 choices: </li></ul><ul><li>Change its growth rate. </li></ul><ul><li>Change its ROA. </li></ul><ul><li>Change its financial policy, meaning the slope of the line. </li></ul><ul><li>Let’s look at Genentech, Inc. and compare their actual growth rates to their g*-estimates. </li></ul>
  13. 13. TABLE 4-1 A Sustainable Growth Analysis of Genentech, Inc., 2003 – 2007*
  14. 14. Respond to Gap <ul><li>Compare 2007 against prior years. </li></ul><ul><li>R stayed at 100%. </li></ul><ul><li>With some exceptions, P, A, and T all rose. </li></ul><ul><li>Look at Figure 4-3. </li></ul><ul><li>In 2007, was Genentech still in cash deficit mode? </li></ul>
  15. 15. FIGURE 4-3 Genentech’s Sustainable Growth Challenges, 2003-2007
  16. 16. What If? <ul><li>Let’s come back to some What If questions. </li></ul><ul><li>Check the bottom of the next slide. </li></ul>
  17. 17. TABLE 4-1 A Sustainable Growth Analysis of Genentech Inc., 2003 – 2007*
  18. 18. What To Do When Actual Growth Exceeds Sustainable Growth? <ul><li>If growth is temporarily too fast, just borrow and wait for it to slow down. </li></ul><ul><li>If not, then there is a laundry list. </li></ul><ul><ul><li>Sell new equity </li></ul></ul><ul><ul><li>Increase financial leverage </li></ul></ul><ul><ul><li>Reduce dividend payout </li></ul></ul><ul><ul><li>Prune marginal activities </li></ul></ul><ul><ul><li>Increase prices </li></ul></ul><ul><ul><li>Merge with a “cash cow” </li></ul></ul>
  19. 19. Sell New Equity <ul><li>Get cash. </li></ul><ul><li>Increase borrowing capacity. </li></ul><ul><li>Difficult to do in most countries. </li></ul>
  20. 20. Increase Leverage <ul><li>Raises cash. </li></ul><ul><li>Also raises risk of bankruptcy. </li></ul>
  21. 21. Reduce the Payout Ratio <ul><li>Saves cash that can be used to build up equity. </li></ul><ul><li>Can anger shareholders who respond by selling their stock, thereby driving down stock price. </li></ul>
  22. 22. Profitable Pruning <ul><li>Raises ROE, and therefore earnings, and therefore retained earnings. </li></ul><ul><li>Retained earnings are part of equity. </li></ul><ul><li>Prune by un-diversifying unrelated product lines with no synergy. </li></ul><ul><ul><li>Who benefits from corporate diversification, shareholders or managers? </li></ul></ul><ul><li>Un-diversifying generates cash from the sale of assets. </li></ul>
  23. 23. Outsourcing <ul><li>Increase asset turnover and therefore ROA. </li></ul>
  24. 24. Pricing <ul><li>Increases ROE, if %-demand doesn’t fall by more than the %-price increase. </li></ul>
  25. 25. Merger <ul><li>Find a cash cow (white knight, if threatened) with deep pockets. </li></ul>
  26. 26. Too Little Growth <ul><li>What to do with the profits? </li></ul><ul><li>In a couple of slides, examine Table 4-3 (Scotts Miracle-Gro). </li></ul><ul><li>Before that, the next slide displays the overall pattern in respect to how companies finance themselves. </li></ul>
  27. 27. TABLE 4-2 Sources of Capital to U. S. Nonfinancial Corporations, 1998-2007
  28. 28. TABLE 4-3 A Sustainable Growth Analysis of Scotts Miracle-Gro Company, 2003-2007*
  29. 29. What Did Scotts Do? <ul><li>Paid dividends. </li></ul><ul><li>Reduced financial leverage. </li></ul><ul><li>Leveraged recap in 2007! </li></ul><ul><li>See Figure 4-4, and ask whether Scotts will need the cash? </li></ul><ul><li>Looking forward, new products, targets to acquire? </li></ul>
  30. 30. FIGURE 4-4 Scotts Miracle-Gro Company’s Sustainable Growth Challenges, 2003-2007
  31. 31. What To Do When Sustainable Growth Exceeds Actual Growth? <ul><li>Ask if situation is temporary. </li></ul><ul><li>If yes, build up cash. </li></ul><ul><li>If no, ask if phenomenon is industry-wide, or within the firm. </li></ul><ul><li>If within the firm, look for new product lines, improvements, etc. </li></ul>
  32. 32. Ignore the Problem? <ul><li>Accumulate cash and slow growth attracts corporate raiders. </li></ul><ul><li>Why? </li></ul><ul><li>What do raiders believe? </li></ul>
  33. 33. Return The Money To The Shareholders <ul><li>Increase dividends. </li></ul><ul><li>Repurchase shares. </li></ul><ul><li>Temptation is to invest in assets that reduce corporate value but increase management’s empire. </li></ul>
  34. 34. Buy Growth <ul><li>Buy other businesses, especially ones that need cash because they are growing rapidly. </li></ul><ul><li>History suggests that returning the money is the better option. </li></ul>
  35. 35. Sustainable Growth and Inflation <ul><li>Inflation increases the nominal value of assets such as AR, inventory, and fixed assets (with a lag). </li></ul><ul><li>These still need to be financed, and the problem is acute if prices are difficult to raise quickly. </li></ul><ul><li>The issue is important if banks miss the connection. </li></ul>
  36. 36. New Equity Financing <ul><li>The next slide illustrates the value of new equity issues over time. </li></ul><ul><li>What happened before and after 1983? </li></ul>
  37. 37. FIGURE 4-5 Net New Equity Issues 1971-2007
  38. 38. FIGURE 4-5 (Continued) Sources. Federal Reserve System, Flow of Funds Accounts of the United States, http://www.federalreserve.gov/releases/z1/Current/data.htm . Bank of Japan, Flow of Funds, Non-financial Corporations, www.boj.or.jp/ . U. K. Office of National Statistics, Financial Account: Non-financial Corporations, www.statistics.gov.uk/ . Note: $169.4 billion of equity issued by Vodafone to acquire Mannesmann in 2000 are omitted from U.K. figures because German equity falls by equal amount.
  39. 39. Acquisitions <ul><li>In the last slide, what happened in 1998? </li></ul><ul><li>Companies reduce their shares by repurchasing them or by acquiring the stock of another firm for cash or debt. </li></ul><ul><li>Was the situation different in the U.K. and Japan? </li></ul><ul><li>The numbers suggest that companies sell new shares about once every 20 years. </li></ul>
  40. 40. Gross Proceeds <ul><li>Check the graph on the next slide. </li></ul><ul><li>Gross proceeds from new stock equaled 9% of total sources of capital. </li></ul><ul><li>Relative to external sources, the number was 22%. </li></ul><ul><li>Check the graph of IPOs relative to gross public equity issues. </li></ul><ul><li>In 2000, IPOs contributed 5% of total external capital. </li></ul>
  41. 41. FIGURE 4-6 Gross Public Equity Issues and Initial Public Offerings, 1970-2006
  42. 42. Note: New equity is publicly issued stock including preferred stock. IPOs exclude over allotment options but include the international tranche, if any. Sources: Federal Reserve Bulletin , Table 1.46, &quot;New Security Issues U.S. Corporations,&quot; various issues for gross public equity issues; Securities Data Corporation as cited in Jay R. Ritter, &quot;Some Factoids About the 2004 IPO Market,&quot; http://bear.cba.ufl.edu/ritter . FIGURE 4-6 (Concluded)
  43. 43. Why Don’t US Companies Issue More Equity? <ul><li>Other sources generated sufficient cash. </li></ul><ul><li>Equity is expensive to issue (flotation). </li></ul><ul><li>Fear of diluting EPS in the short-run. </li></ul><ul><li>Concern that their stock is undervalued in the market. </li></ul><ul><li>Windows close. </li></ul>

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