Managing Growth

Dr. C. Bulent Aybar

Professor of International Finance
 Financing Growth

• Firms can finance their anticipated growth in two ways:

– (1) internally, through the retention of profits (additions to retained
earnings) or
– (2) externally, through the issuance of shares and through borrowing.
• Because external equity financing is more costly than
internal equity financing, firms often try to finance their
expected growth with internally generated equity (retained
earnings).
• For this reason, man­agers need to have an indicator of the
maximum growth their firm can achieve without raising
external equity.

© Dr. C. Bulent Aybar

• The firm's self-sustainable growth rate (SGR) is exactly this
indicator.
• It is the maximum rate of growth in sales a firm can achieve
without is­suing new shares or changing either:
– its operating policy i.e. its operating profit margin and capital
turnover remain the same; or
– its financing policy i.e. its debt-to-equity ra­tio and dividend payout
ratio remain the same.

© Dr. C. Bulent Aybar

 How is the self “Sustainable Growth Rate” is determined?
• Let's start with a simple example and estimate the rate for TJX
Distributors at the end of 2010. The firm's financial data is given in the
following slides.
• We know that the firm's $70 million of equity at the begin­ning of 2010
(the same as end of 2009) generated $10.2 million in earnings after tax.
• The firm retained $7 million and distributed the balance of $3.2
million to owners in the form of dividends.
• As a result, owners' equity increased by 10 percent, from $70 million
to $77 million.
• If the firm wants to maintain its current debt-to-equity ratio, then its
debt must also increase by 10 percent.

© Dr. C. Bulent Aybar

 Balance Sheet: Assets
Balance Sheet December 31st
TJX Distributors (in millions)
2008 2009 2010
Assets
Current Assets
Cash 6 12 8
A/R 44 48 56
Inventories 52 57 72
Prepaid Expenses 2 2 1
Total Current Assets 104 119 137
Non Current Assets
Financial Assets and intangibles 0 0 0
Gross Property Plant and Equipment 90 90 93
Accumulated Depreciation 34 39 40
Net Fixed Assets 56 51 53
Total Non-Current Assets 56 51 53

Total Assets 160 170 190

 Balance Sheet: Liabilities

Balance Sheet December

TJX Distributors 31st (in millions)
Liabilities and Shareholders' Equity 2008 2009 2010
Current Liabilities
Short Term Debt 15 22 23
Notes Payable 7 14 15
Current Portion of LTD 8 8 8
A/P 37 40 48
Accrued Expenses 2 4 4
Total Current Liabilities 54 66 75
Non Current Liabilities
Long Term Debt 42 34 38
Total Non Current Liabilities 42 34 38
Shareholders' Equity 64 70 77
Total Liabilitties and Shareholders' Equity 160 170 190
 Income Statement

TJX Distributors Income Statement December 31st (in millions)

2008 2009 2010
Net Sales 390 420 480
COGS 328 353 400
Gross Profit 62 67 80
SG&A 39.8 43.7 48
Depreciation 5 5 8
Special Items 0 0 0
EBIT 17.2 18.3 24
Net Interest Expense 5.5 5 7
Earnings Before Tax 11.7 13.3 17
Income Tax Expense 4.7 5.3 6.8
Earnings After Tax 7 8 10.2

Dividends 2 2 3.2
Addition on R/E 5 6 7
 Managerial Balance Sheet

TJX Distributors Managerial Balance Sheet December 31st (in millions)

2008 2009 2010
Cash 6 12 8
WCR 59 63 77
Net Fixed Assets 56 51 53
Total Invested Capital 121 126 138

Short Term Debt 15 22 23

Long Term Debt 42 34 38
Shareholders' Equity 64 70 77
Total Capital Employed 121 126 138
 Sustainable Growth Rate
• If both owners' equity and debt increase by 10 percent, their sum, which
is equal to the firm's invested capital, will also increase by 10 percent.
• If the firm's capital turnover (sales divided by invested capital) does not
change, sales will also increase by 10 percent.
• This 10 percent growth in sales is TJX Distributors' self-sustainable
growth rate.
• It is equal to the 10 percent growth in the firm's equity and is
the fast­est growth rate in sales the firm can achieve without
changing its capital structure and operating policy and
without raising new equity through a share issue.

© Dr. C. Bulent Aybar

 Generalization
• From this example, we can now derive a general formula to compute the
self­sustainable growth rate of any firm.
• We define a firm's profit retention rate as the ratio of its addition to
retained earnings to its earnings after tax:
• Retention Ratio (R) = Addition to R/E (t)/Earnings (t-1,t)
• The addition to R/E at time t ; Earnings (or Net Income or Profit After
Tax) has been generated during period (t-1,t).
• Then, the sustainable growth rate which is equal to the rate of increase in
owners' equity, can be written as follows:
SGR=Retained Earnings(t)/Equity(t-1)
SGR=[Retention Ratio x Earnings (t)] /Equity(t-1)
SGR=Retention Ratio x ROE

© Dr. C. Bulent Aybar

 New Sales New Assets Financing

As the chart clearly shows, sales growth requires investment in assets; addition to
R/E and an amount of debt that would preserve the debt equity ratio is used to
finance these investments.
 Sustainable Growth Rate “g*”

• From the previous figure, the limit to growth is the rate at

which equity expands. So focusing on equity expansion
allows us to determine the SGR.
• Therefore, g* is the ratio of the change in equity to equity at
the beginning of the period.

Earnings t ×(1-payout ratio)

g=
Equity t-1

© Dr. C. Bulent Aybar

 Plowback, ROE and SGR

• If the firm pays out all of its earnings as dividends, it cannot

grow its equity.
• If R stands for the plowback ratio or (1-payout ratio), then g*
is the product of R and return on equity.
• g* = R x ROE.
• g* = P x R x A x T or PRAT (as Higgins puts it)
where T is assets/equity based on beginning of period equity,
A is asset turnover, and P is profit margin.

NI t Salest TotalAssetst 1 NI t  R
g   
Salest TotalAssetst 1 Equityt 1 NI t
 Levers of Growth

NI t Salest TotalAssetst 1 NI t  R
g   
Salest TotalAssetst 1 Equityt 1 NI t
• The levers of growth here are PRAT.
– g* is the only sustainable growth rate consistent with these ratios.
– A company that grows too quickly might not be able to increase
operating efficiency, and therefore resort to increased leverage.
– That may increase distress costs and may create substantial
disruptions.
 Balanced Growth

• ROA is Net income / Assets.

• With this definition, g* is the product of (RxT) and ROA,
where RxT reflects financial policy and ROA reflects
operating performance.
 TJX Sustainable Growth Rate and Actual Growth

TJX Sustainable Growth Analysis:

Year Retention Ratio ROE SGR Actual Growth Rate
2009 75.00% 12.50% 9.38% 7.69%
2010 68.63% 14.57% 10.00% 14.29%

• The table above shows the firm's self-sustainable growth rate in 2009 and
2010 (computed according to the equation we developed) and the growth in
sales the firm experienced during these two years.
• TJX Distributors' self­sustainable growth rate was 10 percent in 2010, slightly
higher than its value of 9.4 percent a year earlier. Its sales, however, grew by
14.3 percent during 2010, a rate almost twice that achieved the previous year
(7.7 percent).
• How did TJX grow its sales by 14.3 percent in 2010 with roughly the same self­
sustainable growth rate as in 2009 without issuing new shares?

© Dr. C. Bulent Aybar

• In other words, where did the firm get the additional capital required to grow
sales beyond the self-sustainable growth rate of 10 percent?
TJX Distributors Managerial Balance Sheet December 31st (in millions)
2008 2009 2010
Cash 6 12 8
WCR 59 63 77
Net Fixed Assets 56 51 53
Total Invested Capital 121 126 138

Short Term Debt 15 22 23

Long Term Debt 42 34 38
Shareholders' Equity 64 70 77
Total Capital Employed 121 126 138

• The answer is f in TJX’s managerial balance sheet. Cash decreased from $12
million at the beginning of 2010 to $8 million at the end of that year, a one-
year drop of 33 percent. This means that TJX used its cash holdings to finance
the gap between its self-sustainable growth rate and its growth in sales.

© Dr. C. Bulent Aybar

• This example illustrates an important point:
– firms with sales growth >SGR will eventually experience a cash
deficit;
– firms with sales growth< SGR will eventu­ally generate a cash
surplus.

© Dr. C. Bulent Aybar

SGR, Actual Growth Funding and Investment Problems

This phenomenon is illustrated

in the chart.

• Firms positioned on the line are

in balance. Their SGR is equal
to their growth in sales.

• Firms with sales growth

exceeding their SGR are above
the line and they generate cash
deficits and face a funding
problem.

• Firms with sales growth slower

than their self-sustainable
growth rate are below the line.
They have cash surplus have
an investment problem- they
generate more cash than they
can invest.
• How can management respond to unsustainable levels of
growth in sales?
• For example, suppose TJX expects its sales to grow by 15
percent next year. This growth rate is clearly unsustainable if
TJX maintains its self-sustainable growth rate at its current
level of 10 percent
• If raising new equity is not an option, then the management
will have to make operating or financing decisions that will
raise the firm's self-sustainable growth rate to 15%.
Otherwise, TJX will experience a continued loss of cash next
year that may eventually face a funding and liquidity crisis.

© Dr. C. Bulent Aybar

• If we assume that next year's ROE will be the same as this
year's (14.6%), then one possi­ble option is to retain 100
percent of the firm's profit.
• With a retention rate of one, the firm's self-sustainable
growth rate will be equal to its ROE.
• This option would raise the firm's self­sustainable growth
rate to 14.6 percent, a figure close to the firm's 15 percent
expected growth in sales.
• However, since it implies an elimination of dividend
payments, it is likely to upset shareholders, and it will
probably trigger an negative reaction in the market.
© Dr. C. Bulent Aybar
• Let's assume that TJX management is unwilling to cut
dividends below 20 percent of profits, and want to maintain
debt-to-equity ratio of one.
• With these constraints, the firm's SGR can be increased only
through an improvement in the firm 's operating profitability.
• How much does TJX operating profitability, measured by its
ROIC before tax need to increase to bring its SGR up to its
target?

© Dr. C. Bulent Aybar

• To achieve a target SGR of 15 percent with a retention rate
of 80 percent, TJX’s Return on Equity should increase o
18.7 percent.
• SGR=Retention Ratio x ROE
• SGR=15% = 0.8 x ROE  ROE=18.75%
• To achieve 18.75% ROE, what level of ROICBT should we
reach?

© Dr. C. Bulent Aybar

 ROE and ROICBT

• ROE=(EBIT/Sales) x (Sales/IC) x [(EBT/EBIT)x (IC/Equity)]x(EAT/EBT)

• Where IC=Invested Capital or (Equity + Interest Bearing Debt)
• ROE=Operating Margin x Capital Turnover x Financial Leverage Multiplier x
Tax Effect Ratio
• ROICBT= EBIT/IC
• ROE= ROICBT x Financial Leverage Multiplier x Tax Effect Ratio
• = ROICBT =ROE/(Financial Leverage Multiplier x Tax Effect Ratio)
• ROICBT =18.75%/[(138/70) x (17/24) x (10.2/17)]=22.38%
• This means that TJX’s operating profitability should reach to 22.4%
• Since ROICBT =(EBIT/Sales)x(Sales/IC) we can achieve this either by
increasing operating profitability or asset (capital) turnover or both!

© Dr. C. Bulent Aybar

 Capital Turnover

• Let’s assume that we can improve the operating margin from

5% to 5.5%.
• What should be then the capital turnover ratio?
• Since ROICBT =(EBIT/Sales)x(Sales/IC)
• 22.38%=(5.5%)/Capital Turnover
• Capital Turnover=4.07 ~ 4

© Dr. C. Bulent Aybar

 Prospects for TJX
• How can this objective be achieved? The operations manager will have
to focus first on the firm's WCR; receivables will have to be collected
faster and inventories will have to turn over as quickly as possible .
• Being in the distribution business, however, TJX uses a relatively small
amount of fixed assets, and thus has a lower opportunity to rapidly
improve its fixed asset turnover ratio (sales divided by fixed assets).
• This challenge suggests that it is difficult for TJX to increase its SGR to
15% without raising new equity.
• Given company’s financial constraints, if the firm's management
cannot achieve the targeted improvements in the firm's operations,
the firm's owners will have to inject new equity into the business, issue
new shares, or accept lower-than-expected sales.

© Dr. C. Bulent Aybar

What To Do When Actual Growth Exceeds Sustainable Growth?
– Sell new equity
– Increase financial leverage
– Reduce dividend payout
– Divest marginal activities
– Increase prices
– Merge with a “cash cow”

© Dr. C. Bulent Aybar

 Too Little Growth?
• What to do with the profits?
– In a couple of slides Jos. A. Bank Clothiers is examined!
• Before that, the next slide displays the overall pattern in
respect to how companies finance themselves.
Sources of Capital to U.S. Nonfinancial Corporations, 2001—2010
A Sustainable Growth Analysis of Jos. A. Bank Clothiers, 2006—2010
 What Did Jos. A. Bank Clothiers Do?

• Reduced financial leverage

• Sat on the money
• In the next slide, what do you see about clustering of growth
rates and returns?
• What do you think the company should be thinking about
next?

© Dr. C. Bulent Aybar

Jos. A. Bank Clothiers, Inc. Sustanable Growth Challenges, 2006—2010
 Actual sales growth above a firm’s SGR

• Is not necessarily good for shareholders. It causes one or

more of the defining ratios to change.
• Must be anticipated and planned for. It can be managed by
– Increasing financial leverage.
– Reducing the dividend payout ratio.
– Pruning away marginal activities, products or customers.
– Outsourcing some or all of production.
– Increasing prices.
– Merging with a “cash cow.”
– Selling new equity.

© Dr. C. Bulent Aybar

 Value of Different Type of Growth

Source: Four Cornerstones of Value, McKinsey Consulting

 Actual sales growth below a firm’s SGR

• Generates excess cash that can expose firm as a takeover

target.
• Forces management to find productive uses for the excess
cash, such as
– Reducing financial leverage;
– Returning the money to shareholders: increasing payout ratio or
repurchasing stocks.
– Cutting prices;
– “Buying growth” by acquiring rapidly growing firms in need of
cash.

© Dr. C. Bulent Aybar

 New Equity

• American companies for most of the past 25 years have

retired more equity than they have issued.
• Equity is an important source of cash to a number of smaller,
rapidly growing companies with high growth prospects.
• It is used cautiously because
– Companies in the aggregate have not needed the additional cash.
– Issue costs of equity are high relative to those of debt.
– New equity tends to reduce earnings per share, something most
managers try to avoid
– Managers commonly believe their current share price is
unreasonably low and they can get a better price by waiting.

© Dr. C. Bulent Aybar

 Gross Proceeds
• 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%
 Why Don’t US Companies Issue More Equity?
• Other sources generated sufficient cash
• Equity is expensive to issue (flotation)
• Fear of diluting EPS in the short-run
• Concern that their stock is undervalued in the market
• Windows close

© Dr. C. Bulent Aybar

 Cost of Issuing Equity

Source: Butler et.al (2005) “Stock Market Liquidity and the Cost of Issuing Equity”, Journal of Financial and Quantitative Analysis
Gross New Stock Issues by Corporations and IPOs, 1980—2010
 Gross Equity Issues in the US

US Equity Issues 2003-2013

IPOs and Seasoned Issues as well as Preferred Shares
350.00

300.00

250.00

200.00

150.00

100.00

50.00

-
03 04 05 06 07 08 09 10 11 12 13
20 20 20 20 20 20 20 20 20 20 20

Total Gross Equity Issues True IPOs

Global Equity Issues
IPO Volume Shifted to EMs
Quarterly Stock Repurchases
 High Growth
• High Growth is not the norm. A recent study by McGrath1 asked the
following question:
• “How many publicly traded companies with a market capitalization of
at least US$1 billion grew by 5% each year for five years ending with
2009? “
• She found that only 8% of the 4,793 companies in her sample grew their
revenues by at least 5% year after year, and only 4% achieved a net
income growth of at least 5% in each of the five year
• When she increased period to 10 years, she found out that only 10
companies out of 2,347 could achieve net income growth of 5%, and
only 5 improved revenues and profits each year.

Rita Gunther McGrath Harvard Business Review January – February 2012

© Dr. C. Bulent Aybar

 Blinded by Growth (Javier Estrada, JACF 2012)

• The analysis of growth have shown that firms can go broke

by growing!
• Even high growth companies that look good, do not deliver
much to their shareholders:

© Dr. C. Bulent Aybar

 Google and Amazon

• Google’s corporate performance, as measured by its earnings

growth of over 40% a year, was spectacular. However from
2006 to 2010 Google investors earned an annualized return
of just 1.6% (or a holding-period return of just 7.3%, when
earnings grew over 358%.)
• From July 2004 through the end of 2008, Amazon grew its
earnings by 130.8%, or at an annualized rate of 20.4%.
However investors realized a holding-period negative return
of 5.7%, losing money at the annualized rate of 1.3%.

© Dr. C. Bulent Aybar