Sustainable Growth

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Drivers of Sustainable growth rate:

o Decrease in payout ratio (dividends have remained constant but earnings increased);

o Increase in Financial Leverage;

o Increase in Profit margins;

o Increase in Asset turnover.

What if Company is growing at a faster pace (Growth rate of Sales) than the sustainable growth rate?

o Retained earnings are not enough to cover the necessary investment to grow and the company is bounded to

increase leverage (or reduce its Cash account) unless it issues Equity or Debt.

o Most likely, the firm did not issue equity and has little excess cash.

o If leverage increased more difficult to raise long-term debt.

o Short-term debt is more easily available short-term lenders are de facto senior to long-term lenders short-

term debt alleviates the debt overhang problem at least for a while.

o Constant dividend level +growing income decreasing payout ratio forces to raise leverage.

o Market might have interpreted a cut in dividends as a bad news

How to increase leverage?

o Raise debt and buy back shares or increase cash dividend;

o Share repurchases have several advantages: tax efficient + Investors see share-repurchases as one-time event, but expect cash dividends to be maintained in the future

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Fallacies:

Investors differ in their preferences and needs, and thus want different cash flow streams (True)

What investors will pay is greater if the firm issues securities tailored for different clienteles of investors (False)

Issuing equity will dilute existing shareholders’ ownership so debt financing should be used instead (Incorrect)

Because debt is safer than equity investors demand a lower return for holding debt than for holding equity. (True)

Companies should always finance themselves with debt because they have to give away fewer returns to investors

(False)

Shares repurchase:

Are Shareholders better off with higher EPS?

o NO! Although LVI’s expected EPS rises with leverage → the risk of its EPS also increases.

o While EPS increases on average → this increase is necessary to compensate shareholders for the additional risk they are

taking, so LVI’s share price does not increase as a result of the transaction.

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Cash is like a negative Tax Shield

Personal Taxes

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Financial Distress

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Probability of Distress:

o Volatile Cash Flows;

o Industry change;

o Macro shocks; Technology change;

o Start-up vs. mature business.

Costs of Financial Distress

Ex ante cost of financial distress:

o Need for external financing→ Future profits? Debt ratio?;

o Do costumers and suppliers care about distress→ Unless otherwise stated

say NO;

o Competitive threat if pinched for cash→ Is market competitive→

Depends;

o Agency costs of financial distress→ if there is high excess cash say YES;

Ex post costs of financial distress:

o Are assets hard to redeploy Strong brand name Inventories are

industry specific?