A firm has decided that its optimal capital structure is 100% equity financed. I

Question

A firm has decided that its optimal capital structure is 100% equity financed. It perceives its optimal dividend policy to be a 70% payout ratio. Asset turnover is sales/assets = .4, the profit margin is 10%, and the firm has a target growth rate of 2%.

Calculate the sustainable growth rate. (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

If not, what should the asset turnover be to achieve its goals? (Do not round intermediate calculations. Round your answer to 3 decimal places.)

Instead, what would the profit margin need to be to achieve its goals? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

A firm has decided that its optimal capital structure is 100% equity financed. It perceives its optimal dividend policy to be a 70% payout ratio. Asset turnover is sales/assets = .4, the profit margin is 10%, and the firm has a target growth rate of 2%.

Explanation / Answer

Explanation:

We must calculate ROE to find the sustainable growth rate.To do this we must realise two other relationship.Total turnover ratio is the inverse of capital intensity ratio and the equity multiplyer is 1/D+E But we have 100% equity than EM is 1.Using this relationship we get:

ROE= PM*TAT*EM

=0.10*0.4*1/1

=0.04 or 4%

The plow back ratio is 1 minus dividend payout ratio so b= 1-0.7=0.3

Formulla for sustainable growth rate =(ROE*b)/(1-(ROE*b)

=0.04*0.3/1-(0.04*0.3)

=0.012/1-0.012

=0.012/0.988

=0.0121 or 1.21%

a-2.Firm’s target growth rate is 2% which is more than sustainable growth rate 1.21% so its not consistent with its other goals.If it want to achieve 20% growth rate than have to to borrow extra fund.

b.ROE must rise to = Target growth rate/plow back ratio = 0.02/0.3 =0.067 or 6.67%

ROE=Profit margin* Asset turnover

0.067=0.1*Asset turnover

Asset turnover=0.067/0.1

Asset turnover =0.67

Asset turnover must increase from 0.4 to 0.67 an increase of 0.675(0.67-0.4/0.4)

c.ROE= Asset turnover* net profit margin

0.067 = 0.4* net profit margin

net profit margin =0.067/ 0.4

net profit margin=0.1675 or 16.75%

net profit margin ratio must increase from 10% to 16.75% an increase of 0.675 same as above(16.75-10/10)

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