Question

6. Answer

   1. Suppose the CFO does not want to raise external capital (debt or equity) under any circumstance

      (including when the firm has great investment opportunities but needs external capital to fund them all). What are the firm’s options? How much can the firm grow (Self-supporting growth rate) if no capital is raised (AFN must equal 0).

   2. Is it possible that after the first pass Total Assets > Total Liabilities + Total Equity? If so, under what situation? What do you do in this situation?

   3. Is it possible for an increase in sales to be accompanied by no increase in fixed assets? If so, under what condition can this occur? Can this be sustained in the long-run?

   4. How would economies of scale and lumpy assets affect financial forecasting?

Answer 1

1) Some of the firm's alternative option to debt and equity for the purpose of financing its investment opportunities are as follows :-

A company might raise new funds from the following sources:

• Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:

a) The use of retained earnings as a source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.

• Bank lending

  Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.

  Short term lending may be in the form of:

  a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day;

  b) a short-term loan, for up to three years.

  Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate.

• Government assistance

  The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment.

• Franchising

  Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. For example Mcdonalds franchisees in the Asian market.
  Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs ( architect's work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover.

• Crowdfunding

  Crowdfunding is the most public form of alternative financing. It’s simply an online platform where many investors invest small amounts in a company. Popular crowdfunding sites include Kickstarter, Indiegogo, and GoFundMe. For example, some indie films have raised capital via crowdfunding platforms as both a marketing effort and capital raising. As a result of investor’s donations, they get perks such as rewards, early access, etc.

Self-supporting growth rate

The sustainable growth rate (SGR) is the maximum rate of growth that a company can sustain without having to finance growth with additional equity or debt. The SGR involves maximizing sales and revenue growth without increasing financial leverage. Achieving the SGR can help a company prevent being over-leveraged and avoid financial distress.
SGR Formula and Calculation

SGR = Return on Equity * ( 1 - Dividend Payout Ratio)

First, calculate the ROE of the company. ROE measures the profitability of a company by comparing net income or profit by the company's outstanding shares or shareholders' equity.

Then, subtract the company's dividend payout ratio from 1. The dividend payout ratio is the percentage of earnings per share paid to shareholders as dividends. Finally, multiply the difference by the ROE of the company.

For a company to operate above its SGR, it would need to maximize sales efforts and focus on high-margin products and services. Also, management must have an understanding of the ongoing inventory needed to match and sustain the company's sales level.
The SGR of a company can be achieved if it manages the day-to-day operations properly, including paying its bills and getting paid on time. Accounts payable needs to be managed in a timely manner to keep cash flow running smoothly.
Managing the collection of accounts receivable is also critical to maintaining cash flow and profit margins. Accounts receivable represent money owed by customers to the company.The longer it takes a company to collect its payables and receivables contributes to a higher likelihood that it might have cash flow shortfalls and struggle to fund its operations properly. As a result, the company would need to incur additional debt or equity to make up for this cash flow shortfall.
To maintain the growth rate, companies need to expand into new or other products, which might have lower profit margins.

Suppose a company has an ROE of 15% and a dividend payout ratio of 40%. You would calculate its SGR as follows:
ROE : 0.15 * (1- 0.40 Dividend Payout Ratio)
SGR : 0.09 or 9%
The result above means that the company can safely grow at a rate of 9% using its current resources and revenue without incurring additional debt or issuing equity to fund growth.

If the company wants to accelerate its growth past the 9% threshold to, say, 12%, the company would likely need additional financing. The sustainable growth rate assumes that the company's sales revenue, expenses, payables, and receivables are all currently being managed to maximize effectiveness and efficiency.

In the long-term, companies need to reinvest in themselves through the purchase of fixed assets, e.g. property, plant, and equipment. As a result, the company may need financing to fund its long-term growth through investment.

Capital-intensive industries like oil and gas need to use a combination of debt and equity financing in order to keep operating since their equipment such as oil drilling machines and oil rigs are very expensive.