Question

As a firm grows, it must support increases in revenue with new investments in assets. The self-supporting, or sustainable, 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 the following case of Blue Elk Manufacturing:

Blue Elk Manufacturing has no debt in its capital structure and has $100,000,000 in assets. Its sales revenues last year were $30,000,000 with a net income of $1,500,000. The company distributed $145,000 as dividends to its shareholders last year.

Given the information above, what is Blue Elk Manufacturing’s sustainable growth rate?

2.946184%

4.3402367%

1.37%

0.1452622%

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

A. The firm maintains a constant net profit margin.

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

C. The firm pays no dividends.

D. The firm maintains a constant ratio of liabilities to equity.

Answer 1

Part 1

A sustainable growth rate is a maximum rate at which a company can grow without raising the capital from outside in the form of equity or debt.

To calculate the sustainable growth rate we will use the following formula

g= ROE*(1- Divident payout ratio)

g= sustainable growth rate

ROE- Return on equity

Divident payout ratio= is the ratio of the total dividend paid out to the investors to net income

Divident payout ratio = $145000 / $1500000

= 9.67% or 0.097

ROE= Net income / Share holder's equity

= $1500000 / $10000000

= 1.5%

g= 1.5%*9.67%

g= 0.145%

So sustainable growth rate for Blue Elk Manufacturing is 0.145%

Part 2

The sustainable growth model assumes that there no new debt or equity is added to the capital so the correct answer is

D. The firm maintains a constant ratio of liabilities to equity.

A. Not applicable because the net profit margin can change and the firm can still maintain a sustainable growth rate.

B. Not applicable

C. Not applicable, the Firm can pay dividends along with maintaining a sustainable growth rate. To increase g firm can reduce or stop paying dividends.