Introductory Corporate Finance: Financial Planning External Financing Needed EFN Formula EFN Asset Growth Spontaneous Liabilities Growth Retained Earnings Addition

What This Is

External Financing Needed (EFN) is a crucial concept in corporate finance that measures the amount of external funding a company requires to achieve its desired growth rate. It's essential to understand EFN because it helps companies determine their financing needs, evaluate their capital structure, and make informed investment decisions. For example, let's consider Tesla, which aims to increase its sales by 20% annually. If its spontaneous liabilities grow by 10% and retained earnings addition is $100 million, the EFN would be $200 million ($400 million in asset growth - $100 million in retained earnings addition - $200 million in spontaneous liabilities growth).

Key Formulas & Models

• EFN = Asset Growth – (Spontaneous Liabilities Growth + Retained Earnings Addition) – measures the amount of external funding required to achieve desired growth rate.
  • Asset Growth: the desired growth rate of a company's assets.
  • Spontaneous Liabilities Growth: the growth rate of a company's liabilities that are not controlled by management.
  • Retained Earnings Addition: the amount of retained earnings added to the company's assets.
• Asset Growth = (1 + g)A0 – the desired growth rate of a company's assets.
  • g: the desired growth rate.
  • A0: the initial asset value.
• Spontaneous Liabilities Growth = (1 + s)L0 – the growth rate of a company's liabilities that are not controlled by management.
  • s: the growth rate of spontaneous liabilities.
  • L0: the initial liability value.
• Retained Earnings Addition = (1 + r)E0 – the amount of retained earnings added to the company's assets.
  • r: the retention ratio.
  • E0: the initial retained earnings value.

Step-by-Step Calculation

1. Determine the desired growth rate of the company's assets (Asset Growth).
2. Calculate the growth rate of spontaneous liabilities (Spontaneous Liabilities Growth).
3. Determine the retention ratio and calculate the retained earnings addition (Retained Earnings Addition).
4. Apply the EFN formula: EFN = Asset Growth – (Spontaneous Liabilities Growth + Retained Earnings Addition).
5. Evaluate the EFN to determine the amount of external funding required.
6. Consider the company's capital structure and financing options to determine the optimal amount of external funding.

Common Mistakes

• Mistake: Ignoring the growth rate of spontaneous liabilities.
  • Correction: Include the growth rate of spontaneous liabilities in the EFN calculation to accurately determine the amount of external funding required.
  • Counterexample: A company with a 10% growth rate in spontaneous liabilities and a 5% retention ratio would require more external funding than a company with a 5% growth rate in spontaneous liabilities and a 5% retention ratio.
• Mistake: Failing to consider the retention ratio.
  • Correction: Include the retention ratio in the EFN calculation to accurately determine the amount of retained earnings added to the company's assets.
  • Counterexample: A company with a 10% retention ratio and a 5% growth rate in spontaneous liabilities would require more external funding than a company with a 5% retention ratio and a 5% growth rate in spontaneous liabilities.
• Mistake: Using the wrong formula for EFN.
  • Correction: Use the correct formula: EFN = Asset Growth – (Spontaneous Liabilities Growth + Retained Earnings Addition).
  • Counterexample: A company with a 10% growth rate in assets, a 5% growth rate in spontaneous liabilities, and a 5% retention ratio would require more external funding than a company with a 5% growth rate in assets, a 5% growth rate in spontaneous liabilities, and a 5% retention ratio.

Exam / CFA Tips

• Be careful with the formula: EFN = Asset Growth – (Spontaneous Liabilities Growth + Retained Earnings Addition).
• Consider the company's capital structure and financing options when evaluating the EFN.
• Pay attention to the growth rate of spontaneous liabilities and the retention ratio when calculating the EFN.

Quick Practice Problem

A company has a desired growth rate of 15%, a 5% growth rate in spontaneous liabilities, and a 20% retention ratio. What is the EFN?

Answer: EFN = (1 + 0.15)A0 - ((1 + 0.05)L0 + (1 + 0.20)E0) = $200 million.

Last-Minute Cram Sheet

• EFN = Asset Growth – (Spontaneous Liabilities Growth + Retained Earnings Addition).
• Asset Growth = (1 + g)A0.
• Spontaneous Liabilities Growth = (1 + s)L0.
• Retained Earnings Addition = (1 + r)E0.
• ⚠️ In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• ⚠️ The growth rate of spontaneous liabilities is not always 0.
• ⚠️ The retention ratio is not always 0.
• EFN is a measure of the amount of external funding required to achieve desired growth rate.
• EFN is used to evaluate a company's capital structure and financing options.
• EFN is an important concept in corporate finance.