Question

As a firm grows, it must support increases in revenue with new investments in assets. The self-supporting growth model helps a firm assess how rapidly it can grow, while maintaining a balance between its cash outflows (increases in noncash assets) and inflows (funds resulting from increases in liabilities or equity).

Consider this case:

Bohemian Manufacturing Company has no debt in its capital structure and has $150 million in assets. Its sales revenues last year were $90 million with a net income of $5 million. The company distributed $1.30 million as dividends to its shareholders last year.

What is the firm’s self-supporting, growth rate? (Note: Do not round your intermediate calculations.)

a. 0.87%

b. 4.38%

c. 0.74%

d. 2.53%

Which of the following are assumptions of the self-supporting growth model? Check all that apply.

- The firm pays out a constant proportion of its earnings as dividends.

- The firm’s total asset turnover ratio remains constant.

- The firm’s liabilities and equity must increase at the same rate.

- The firm will not issue any new common stock next year.

Answer 1

Answer to 1.

Return on Equity(ROE) = Net Income / Total Shareholder's Equity

= $ 5 million / $ 150 million

= 0.033

or = 3.33%

ROE = 3.33%

Note : Since the Company has no debt in its capital structure and has $150 million in assets. Therefore, Shareholder's Equity = $ 150 million .

The Company has no Debt so, Net Earning available to Equity Shareholders is equal to Net Income .

So, Net Earning available to Equity Shareholders = $ 5 million

Dividend Distributed = $ 1.30 million

Self - -supporting growth model = Return on Equity * (1 - Dividend Payout Ratio)

Self - -supporting growth model = ROE * Retention Ratio

= 3.33% * 74%

= 2.4642%

Where, Dividend Payout Ratio = Dividend Paid / Net Income

Dividend Payout Ratio = $ 1.30 million / $ 5 miilion

Dividend Payout Ratio = 0.26

Dividend Payout Ratio = 26%

Retention Ratio = 1 - Dividend Payout Ratio

= 1 - 0.26  

= 0.74

Retention Ratio = 74%

So, OPTION D is the Correct Answer , approx 2.53 % is the growth model as per Self -supporting growth model

Answer to 2.

Which of the following are assumptions of the self-supporting growth model?

The firm will not issue any new common stock next year : Correct assumption

The Self Sustainable growth rate tell us that the company can earn this rate even without need to arrenge any finance be in the form of Equity or Finance.

So, The Firm Will not issue any Common Stock next year , meaning capital structure will not changed.

The firm pays out a constant proportion of its earnings as dividends : Correct assumption

In this model, Growth rate which is Return on Equity * Retention Ratio is assumed to be constant till perpetual, meaning no change in Growth rate under this model.

So, Constant Proportion of Earnings as dividend stands correct assumption.

The firm’s total asset turnover ratio remains constant : Correct assumption

this model assumes proportion of assets and sales remains same .

So, Total Assets Turnover = Net sales / Total Assets

So, The ratio should remain stable/ constant.

The firm’s liabilities and equity must increase at the same rate : Correct

Since there is no change in Capital Structure of the company and it will only contain equity .

Further, Assets will remain same .

So, yes the Firm's Liabilities and equities change at same rate in order to main the stable growth rate .

All the points are covered in assumption .