Question

The GAMA Company has the following results.

Net sales = $6,000,000

Net total assets = $4,000,000

Depreciation = $160,000

Net income = $400,000

Long-term debt = $2,000,000

Equity = $1,160,000

Dividends = 160,000

a. Compute GAMA’s ROE directly. Confirm this using the three components (DuPont Equation).

b. Using the ROE computed in Part a, what is the expected sustainable growth rate forGAMA?

c. Assuming the firm’s net profit margin (Net Income / Sales) went to 0.04, what would happen to GAMA’s Net Income and ROE?

d. Using the ROE in Part c, what is the expected sustainable growth rate? What if dividends were only $40,000?

Answer 1

a. Compute GAMA’s ROE directly. Confirm this using the three components (DuPont Equation).

Calculating the ROE using the three components

Return on Earnings = Net Income / Equity = (Net Income /Sales) * (Net Sales/common equity) = (400,000/6,000,000) * (6,000,000/1,160,000) = 0.345

Therefore ROE = 34.50%

b. Using the ROE computed in Part a, what is the expected sustainable growth rate forGAMA?

Sustainable Growth Rate = Retention rate * ROE

Retention Rate = 1-(Dividends Declared/Net Earnings) = 1-(160000/400000) = 0.60

ROE = 0.345

Sustainable Growth Rate = 0.60 * 0.345 = 0.207 or 20.7%

c. Assuming the firm’s net profit margin (Net Income / Sales) went to 0.04, what would happen to GAMA’s Net Income and ROE?

Net Profit Margin = Net Income/Net Sales

0.04 = Net Income/6,000,000 = Net Income = 6,000,000*0.04

Net Income = $240,000

ROE = Net Income/Equity = 240000/1160,000 = 0.20689 or 20.69%

d. Using the ROE in Part c, what is the expected sustainable growth rate? What if dividends were only $40,000?

Sustainable Growth Rate = Retention rate * ROE

Retention rate = 0.60

New ROE = 20.68%

Sustainable Growth Rate = 0.60 * 0.2068 = 0.12408 = 12.41%

If the dividends were $40,000

Sustainable Growth Rate = Retention Rate * ROE

New Retention Rate = 1-(Dividends declared/Net Earnings) = 1-(40000/400,000) = 1-0.10 = 0.90

Sustainable Growth rate = 0.90 * 0.345 = 0.3105

or Sustainable Growth Rate = 31.05%