Question 19.2: Empire’s Ambitious Growth Plan SITUATION: You are part of th...
Empire’s Ambitious Growth Plan
SITUATION: You are part of the Empire Enterprises finance team. The firm’s strategic plan calls for revenues to grow at 20 percent next year. As mentioned, the board of directors is not interested in using any additional external equity financing. Some members of the team question whether these goals are realistic.
You have just been asked to comment on the proposed growth plan at a meeting. You have a little over an hour to prepare. During the time available, you completed the fol- lowing calculations using data from the most recent and the pro forma income statements and balance sheets (Exhibits 19.9 and 19.10):
• EFN = (Growth rate × Initial assets) − Addition to retained earnings = (0.20 × $50 million) − $4.8 million = $5.2 million
• IGR = Addition to retained earnings/initial assets = $4.8 million/$50 million = 0.96, or 9.6%
• SGR = Plowback ratio × ROE = 0.40 × 0.333 = 13.3%
Given the above information, what can you say about this ambitious growth plan?
\begin{matrix} &Income \ Statement& \\\\ Net \ sales &&& \$ 100.0 \\ Costs &&& \underline{ 90.0} \\ Net \ income &&& \underline{\underline{\$ 10.0}} \\ Dividends &&& \$ 6.0 \\ Addition \ to \ retained \ earnings &&& \$ 4.0 \end{matrix}
| Balance Sheet | |||||
| Assets | Liabilities and Stockholders’ Equity | ||||
| Precentage of Sales | Precentage of Sales | ||||
| Assets | \underline{\$50.0} | 20.0% | Total debt | $20.00 | n/a |
| Total assets | \underline{\underline{\$50.0}} | Equity | \underline{30.0} | n/a | |
| Total liabilities and stockholders’ equity | \underline{\underline{\$50.0}} | ||||
| Balance Sheet | |||||
| Assets | Liabilities and Stockholders’ Equity | ||||
| Projected | Change | Projected | Change | ||
| Assets | \underline{\$60.0} | \underline{\$10.0} | Total debt | $20.0 | $0.0 |
| Total assets | \underline{\underline{\$60.0}} | \underline{\underline{\$10.0}} | Equity | \underline{34.8} | \underline{4.8} |
| Total liabilities and stockholders’ equity | \underline{\underline{\$54.8}} | \underline{\underline{\$4.8}} | |||
| External financing needed (EFN) | $5.20 | $5.2 | |||
DECISION: You begin by applauding the visionary nature of the strategic plan. Clearly, you want to keep your job. You point out, however, that the firm is facing some challenges. First, Empire’s IGR is 9.6 percent, which is the maximum growth rate the firm can achieve without any kind of external financing. This amount is substantially below the desired growth rate of 20 percent. Second, you note that Empire’s EFN is $5.2 million. This means that $5.2 million of external capital will have to be raised by selling equity, debt, or some combination of the two. Finally, Empire’s SGR is 13.3 percent—also below the 20 percent growth target. Empire cannot grow more than 13.3 percent without selling equity if management wants to keep the firm’s capital structure at its current level.