Question

Can you explain why the internal growth rate of the firm is same as the sustainable growth rate for a 100% equity financed firm?

Answer 1

Internal growth rate is the growth rate that a company can achieve only using the retained earnings without external financing. Formula for Internal growth rate is

Internal growth rate = Retention ratio*ROA

or, Internal growth rate =(Reinvested earning/Net Income)*(Net income/Total Assets)

Retention ratio can also be achieved as 1 minus dividend payout ratio.

On the other hand, sustainable growth rate allows the use of external financing but in proportion to the capital mix.

Sustainable growth rate = (Retained earning / Net income)*(Net Income/Equity)

We can compare the Internal growth rate with sustainable growth rate as follows:

Internal Growth rate = Sustainable growth rate*(Equity/ Assets)

In the absence of external financing, the internal growth rate is same as sustainable gowth rate as 100% equity financiang is used to raise the capital which results in equity equal to assets.

The formula of internal gowth rate and sustainable growth rate will be same making the assets equals to equity. Thus, with 100% equity internal growth rate of the firm is same as the sustainable growth rate.