LONG-TERM FINANCIAL PLANNING
Answers to Concepts Review and Critical Thinking Questions
1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in
fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put
differently, a firm’s future need for things like capital assets, employees, inventory, and financing are
determined by its future sales level.
2. Two assumptions of the sustainable growth formula are that the company does not want to sell new equity, and
that financial policy is fixed. If the company raises outside equity, or increases its debt-equity ratio it can grow
at a higher rate than the sustainable growth rate. Of course the company could also grow faster than its profit
margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover
3. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates that
there is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable growth
rate is certainly greater than 15%, because there is additional debt financing used in that case (assuming the firm
is not 100% equity-financed). As the retention ratio is increased, the firm has more internal sources of funding,
so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out
all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of
accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets.
4. The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN indicates that
there is excess financing still available. If the firm is 100% equity financed, then the sustainable and internal
growth rates are equal and the internal growth rate would be greater than 20%. However, when the firm has
some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether
the internal growth rate would be greater than or less than 20%. If the retention ratio is increased, the firm will
have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio
constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the
retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change
in total assets.
5. Presumably not, but, of course, if the product had been much less popular, then a similar fate would have
awaited due to lack of sales.
6. Since customers did not pay until shipment, receivables rose. The firm’s NWC, but not its cash, increased. At
the same time, costs were rising faster than cash revenues, so operating cash flow declined. The firm’s capital
spending was also rising. Thus, all three components of cash flow from assets were negatively impacted.