Question

Abacus Co. wishes to maintain a growth rate of 14 percent a year, a debt–equity ratio of 1.3, and a dividend payout ratio of 25 percent. The ratio of total assets to sales is constant at 0.6. What profit margin must the firm achieve? (in %)

Answer 1

(i) Retention rate = 1 - Payout ratio

= 1 - 0.25

= 0.75 or 75%

(ii) sustainable growth rate = Return on equity x Retention rate

14 = Return on equity x 0.75

Return on equity = 18.67%

(iii) ratio of total assets to sales = 0.6

Total assets = 0.6 Sales

Total Assets turnover ratio = Sales/Total assets = 1/0.6

= 1.67

(iv) debt–equity ratio =1.3

Debt = 1.3 Equity

Total assets = Debt + Equity

= 1.3 Equity + Equity

= 2.3 Equity

(iv) Return on equity = Profit margin x Total asset turnover x Equity multiplier

18.67 = Profit margin x 1.67 x (Total assets/Equity)

18.67 = Profit margin x 1.67 x (2.3 Equity/Equity)

18.67 = Profit margin x 1.67 x 2.3

Profit margin = 18.67/(1.67 x 2.3)

= 18.67/3.841

= 4.86%

Hence, profit margin to be earned = 4.86%

Note: Exact answer may slightly vary due to rounding off. Return on equity was 18.66666666666% but it was taken as 18.67%, total assets turnover ratio was 1.66666666666% but it was taken as 1.67%.

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