Robert F. Bruner

Applied Mergers and Acquisitions


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Debt-to-Equity Ratio Charming Shoppes, Inc. 13.2% 15% 14.5% A 6.1% 12.6% Deb Shops, Inc. 11.3% 20% 14.0% Baa 6.6% 2.0% The Dress Barn 17.5% 0% 17.5% Baa 6.6% 0.0% Petrie Stores Corporation 8.0% 25% 10.0% Baa 6.6% 19.0% The Limited, Inc. 27.6% 22% 23.0% A 6.1% 53.8%

      The exhibit reveals dramatic strategic disparities among these competitors. The Limited enjoys an unusually robust self-sustainable growth rate of 27.6 percent, stemming in large part from its high internal profitability and its relatively more aggressive use of debt capital. At the other end of the spectrum, Petrie Stores Corporation appears to be able to self-sustain only an 8 percent annual growth rate; this is due largely to its relatively low internal profitability. The Dress Barn stands out for its unusual set of financial policies: no debt and no dividends. Given that this firm has the second-highest internal profitability in the competitive group, The Dress Barn could probably boost its self-sustainable growth rate materially by even modest use of leverage.

      Analysis of Policies within a Firm

Acme Corporation Self-Sustainable Growth Rate Analysis Assumptions and Result
Dividend payout ratio 50%
Target debt/equity ratio 25%
Expected return on equity 13%
Expected return on total capital 11.4%
Expected after-tax cost of debt 5%
New issues of common equity Nil
Self-sustainable growth rate 6.5%
Change in Policy New Policy Target Existing Policy Required Change
Increase debt/equity ratio. Finance the growth with debt. D/E = 2.9 D/E = .25 Tenfold relevering.
Sell equity. DPO = –115% (i.e., sell about as much equity each year as you generate internally) DPO = 50% (i.e., no equity sales) Drop the dividend. Sell equity.
Improve internal profitability. ROE = 30% ROTC = 25% ROE = 13% ROTC = 11.4% More than double the margins.
Improve internal profitability and increase debt/equity ratio. ROTC = 18% D/E = .667 ROTC = 11.4% D/E = .25 Increase margins and leverage a lot.
Cut dividend payout ratio and improve internal profitability and increase debt/equity ratio. DPO = 11.8% ROTC = 13% D/E = .50 DPO = 25% ROTC = 11.4% D/E = .25 Cut dividend in half. Double the leverage. Increase margins.

      Considering the various advantages and disadvantages, the fifth alternative, which involves a blend of changes in all policy areas, seems most attractive. A higher debt/equity ratio could still be consistent with average ratios in the industry and with the firm’s internal debt rating preferences. While the owners of the firm would feel the cut in dividend payments, the improvement in competitive standing might translate into capital gains later. Of all the policy changes, an increase in ROTC from 11.4 percent to 13 percent would be the hardest to implement, though management believes it is obtainable.

      In the hands of an artful analyst, the popular model can yield valuable insights. But it can be abused and misused easily. Financial executives and their advisers should beware of six potential problems:

      1 The model says nothing about value creation. The popular model describes the maximum growth rate in assets, not market value. All too often, financial advisers take for granted the wisdom of stated growth targets—but such growth targets are usually stated in terms of sales or assets and may be realizable only with the destruction of market value of equity and/or debt. The model should not be used without some complementary analysis proving the economic attractiveness of the growth goals. A much more detailed