Sustainable Growth. A firm wants to maintain its capital structure and is curren

Question

Sustainable Growth. A firm wants to maintain its capital structure and is currently 100 percent equity financed. It perceives its optimal dividend policy to be a 40 percent payout ratio. Current asset turnover (sales/initial assets) 5 .8 and the profit margin (net income/sales) is 10 percent. The firm has a target growth rate of 5 percent for the next year but will not issue any equity.

a. Is the firm’s target growth rate consistent with its other goals?

b. If not, by how much does it need to increase asset turnover to achieve its goals?

c. How much would it need to increase the profit margin instead?

Explanation / Answer

As per Du pont formula :

Required Return on Equity (ROE) = profit margin * asset turnover* Financial leverage

Financial leverage shall be 1 because it is all equity firm.

= 10% * 5.8 *1

= 58%

As per Growth rate formula :

Required Growth rate = ROE * (1- payout ratio)

= 58% * (1-40%)

= 34.8%

a. Target growth rate (5%) of the firm is less that the required growth rate (34.8%). Hence firm’s target growth rate is not consistent with its other goals.

b. Calculation of required increase in asset turnover to achieve its goals:

IF the Target growth rate is 5%, then ROE shall be = Target growth rate / (1- Payout ratio)

= 5% / (1-40%)

= 8.33%

Now we know that:

Required Return on Equity (ROE) = profit margin * asset turnover* Financial leverage

Hence ,

8.33% = 10% * required asset turnover * 1

Required asset turnover = 8.33%/ 10% = 0.8333

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