Question

In: Finance

Firm UUU earns $0.2 in profit on every $1 of sales, has $0.5 in assets for...

Firm UUU earns $0.2 in profit on every $1 of sales, has $0.5 in assets for every $1 of sales and for has $2 debt on every $1 equity. The firm pays out 20 percent of its profits to its shareholders. What is the internal growth rate? What is the sustainable growth rate?

Solutions

Expert Solution

Assume Total sales =   $1
Profit is 0.2 on $1 sales = $0.2
Assets 0.5 for $1 sales = $0.5
Debt equity ratio = $2 for $1 equity
Debt + Equity = Total assets = $0.5
So, Equity = 0.5 * 1/3 = $0.16667 0.166667
Payout ratio = 20% or 0.2
So, Retention ratio = 80% or 0.8
(a) Calculation of Internal growth rate
Internal growth rate is maximum growth rate that firm can achieve without use of external financing.
Internal Growth rate formula = Return on Assets * Retention ratio
_______________________________
1 - (Return on assets * Retention ratio)
Return on assets = Profit (Net income ) /   Assets
0.2 / 0.5
0.4
Internal growth rate = ( 0.4 * 0.8 )  
__________
1 - (0.4 * 0.8)
0.470588 or 47.06%
So, Internal growth rate is 47.06%
(b) Calculation of Sustainable growth rate

Sustainable Growth rate = Return on Equity * Retention ratio.

Return on equity = Profit ( Net income ) / Equity
0.2 / 0.16667
1.2
Sustainable growth rate = 1.2 * 0.80
0.96 or 96%
So, Firm's sustainable growth rate is 96%

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