New capital requirement of a growing company

A hypothetical example to understand the above more clearly.  The following reasonable assumptions can be made based on this example:

Sales to Assets Ratio = 2x
Profit after Tax to Sales = 6%
Debt to Equity Ratio = 1.2
Dividend Payout Ratio = 0.5
Sales in Year 0 = $10 million
Growth Rate = 10% pa

Simplified Balance Sheet ($M)

At End of Year 0
Assets 5.00
Financed by:
Shareholders' Equity 3.33
Borrowing 1.67

Simplified P&L Statement ($M)

For Year 1
Sales 11.00
Profit after Tax 0.66
Dividend 0.33
Retained Profit 0.33

Simplified Balance Sheet ($M)

At End of Year 1
#   Assets 5.50
Financed by:
@  Shareholders' Equity 3.66
**  Borrowing 1.84

Notes on Balance Sheet at Year 1
#     Increase at the same rate as sales
@    = 3.33 (at Year 0) + 0.33 (Retained Profit of Year 1)
**   By difference = 5.50 - 3.66

• From the above example, by maintaining the D/E ratio at around 1:2 (3.66 = 2 x 1.83), the company has no difficulty in financing a 10 percent increase in sales in one year. 
  
• By having a zero dividend payout, it can in fact grow at 18 percent per year without increasing its D/E ratio.

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Under the normal circumstances, a company should be able to finance its additional purchase of assets from either

• retained earnings or
• new borrowing or
• a combination of the two.

But, companies may have to raise new capital by making rights issues under three types of abnormal circumstances. These three cases are:

(1) The company is improperly managed such that it is either not very profitable (or even losing a lot of money) such that the incoming cash is not adequate to support the need to purchase more assets. Or owing to poor management of its assets, it now requires a lot more assets to support its operations.

(2) The company is moving into another line of business which is large relative to its current size and it requires a great deal of additional capital to start up the new venture.

(3) The company is in a very fast growing business. In fact, it is so fast growing that retained earnings and new borrowing alone are insufficient to sustain the growth.

In order to be a prudent investor, we must analyse the situation of the company which has announced a rights issue carefully to see which category it falls into in the first place.