Question

Discuss why increasing the growth rate of sales is not always a way to increase the value of a company. Use the concepts in class to defend your answer.

Discuss each question thoroughly using essay format and/or mathematical theorem where you deem necessary. Answers may be written or typed; answers should not exceed ½ page in length.

Answer 1

Value of the firm=free cash flow/(WACC-growth rate) or dividend/(cost of equity-growth rate)

Now we see above that if growth rate of sales is to be increased, many of thr below cases can occur where value of firm does not increase.

1. New assets need to be acquired and no change in profit margin: capex might have to be incurred which would decrease free cash flow despite increase in net income. This would lower the value of the firm.

2. Additional funds would need to be sourced externally which might increase WACC thus decreasing value of firm.

3. Sales can be increased by giving discounts (thus decreasing price) thus decreasing profit margins or net income. Hence, value of the firm might decrease.

4. Sales can be increased by increasing price but then if elasticity of product is high quantity will fall hugely which would thus decrease net income thus decreasing value of firm