Question

Assuming the following ratios are constant,

Total asset turnover	=	2.00
Profit margin	=	8%
Equity multiplier	=	1.50
Pay-out ratio	=	60%

A. What is the sustainable growth rate?

B. What is the internal growth rate?

C. What is the difference between the above two rates in terms of meaning, assumption and application? Discuss.

Answer 1

A

SUSTAINABLE GROWTH RATE FORMULA = ROE x RETENTION RATIO

ROE =	Net Profit Margin * Assets turnover * Equity Multiplier(Or leverage ratio)
	8% * 2 * 1.5
	24%
Retention Ratio =	( 1 - Dividend Payout Ratio)
	1 - 60%
	40% OR 0.4

Sustainable Growth Rate =	ROE x retention ratio /1 - ROEx Retnetion ratio
	0.4 * 24% / 1 - (24%x0.4)
	10.62%

B

ROA = NET PROFIT MARGIN X ASSET TURNOVER RATIO

= 8% x 2

= 16%

RETENTION RATIO = 0.4 OR 40%

INTERNAL GROWTH RATE = ROA x RENTENTION RATIO / 1-ROA x RENTION RATIO

= 16% x 0.4 / 1 - (16%x 0.4)

=6.4% / 0.936

= 6.84%

C

The IGR informs us of the rate of growth a firm can attain via internal resources (accumulated retained earnings and existing productive capital assets), while the SGR lets us know what type of growth the firm might be able to sustain over time with given its equity capital structure and ability to attract debt financing, while keeping its debt ratio constant.