FIN 300 Study Guide - Dividend Payout Ratio, Pro Forma, Operating Cash Flow

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coffeeprairie-dog40

5 May 2011

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Answers to concepts review and critical thinking questions: 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. If the company raises outside equity, or increases its debt-equity ratio it can grow at a higher rate than the sustainable growth rate. 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 is 100% equity financed, then the sustainable and internal growth rates are equal and the internal growth rate would be greater than 20%.

Related Questions

Use the data below to solve for the sustainable growth rates for 2011 to 2015. What is the sustainable growth rate for each year? Based on your analysis of the sustainable growth rate between 2011 and 2015, what are your recommendations for the firm?

	2011	2012	2013	2014	2015
Profit Margin	17	17	79.3	22.8	23.6
Retention Ratio	1	1	1	1	1
Asset Turnover	0.38	0.49	0.55	0.63	0.62
Financial Leverage	1.64	1.44	1.79	1.99	2
Sustainable Growth Rate
Actual Growth Rate	26.1	40.1	43.5	40	26.3

Financial Analysis Exercise IV

Part A: Weighted Average Cost of Capital (WACC)

Here again is the formula for WACC. For simplicity the term for preferred stock has been removed:

Go to http://thatswacc.com/[1] and enter the ticker symbol for the stock you selected and click on the tab entitled âCalculate WACC.â

Complete the following tables:

Name of Company/Stock	Walt Disney
Ticker Symbol	DIS

From the http://thatswacc.com/ results for your company:

WACC	13.50%
Cost of debt, i_D	0
Corporate tax rate, T_C	34.98
Total debt, D	48,768,000
Total equity, E	10,251,618,400
Total firm value, V	10,300,386,400
Cost of equity, i_E	13.56%

CAPM Components

Beta, Î²	1.32
Historical market return, i_M	Assumed 11%
Risk-free rate, i_F	Assumed 3%

Using data in the table confirm the accuracy of the siteâs WACC calculation:

Weight of Equity
Weighted Average Cost of Equity	_E
Weight of Debt
Pre-Tax Weighted Average Cost of Debt	_D
After-Tax Weighted Cost of Debt	_D Â· (1- T_C)
Weighted Average Cost of Capital	= Â· i_E + Â· i_D Â· (1-T_c)

Part B: Dividend Payout and Growth Ratios

Recall from Module 1 the following two ratios:

Internal growth rate = (ROA â RR) / [1-(ROA â RR)] (Eq. 3-30)

where RR = Retention ratio = (Addition to retained earnings)/Net income (Eq. 3-31)

The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets

Sustainable growth rate = (ROE â RR) / [1-(ROE â RR)] (Eq. 3-33)

If the firm uses retained earnings to support asset growth, the firmâs capital structure will change over time, i.e., the share of equity will increase relative to debt

To maintain the same capital structure managers must use both debt and equity financing to support asset growth

The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio

1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:

= (ROA â RR) / [1-(ROA â RR)]

2. Calculate the firmâs sustainable growth rate for the last fiscal year:

= (ROE â RR) / [1-(ROE â RR)]

Part C.

Consider your results for Parts A and B. If the chosen firm grows at its internal growth rate, increasing assets only with its retained earnings, how will this likely affect its WACC? Show calculations.

If the chosen firm grows at its sustainable growth rate with increases in both its retained earnings and debt, maintaining a constant debt ratio, how will this affect its WACC?

If the chosen firm attempts to grow faster than its sustainable growth rate with modest increases in its debt ratio, how will this likely affect its WACC? What about very large increases in its debt ratio? Explain.

[1] The accessibility of this site is assumed. Should it not be accessible, please follow the instructions in the Appendix at the end of this document.