Question

4. Sustainable growth As a firm grows, it must support increases in revenue with new investments in assets. The self-supporting 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 this case: Green Caterpillar Garden Supplies Inc. has no debt in its capital structure and has $150 million in assets. Its sales revenues last year were $75 million with a net income of $5 million. The company distributed $1.60 million as dividends to its shareholders last year. What is the firm’s self-supporting, growth rate? (Note: Do not round your intermediate calculations.)

1.00%

1.08%

2.32%

4.60%

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

___The firm will not issue any new common stock next year.

___The firm’s total asset turnover ratio remains constant.

___The firm pays no dividends.

___The firm’s liabilities and equity must increase at the same rate.

Answer 1

Answer a.

Last Year:

Return on Equity, ROE = Net Income / Total Equity
Return on Equity, ROE = $5 million / $150 million
Return on Equity, ROE = 0.03333 or 3.333%

Payout Ratio = Dividends / Net Income
Payout Ratio = $1.60 million / $5 million
Payout Ratio = 32%

Retention Ratio, b = 1 - Payout Ratio
Retention Ratio, b = 1 - 0.32
Retention Ratio, b = 0.68

Self-Supporting Growth Rate = [ROE * b] / [1 - ROE * b]
Self-Supporting Growth Rate = [0.03333 * 0.68] / [1 - 0.03333 * 0.68]
Self-Supporting Growth Rate = 0.0226644 / 0.9773356
Self-Supporting Growth Rate = 0.0232 or 2.32%

Answer b.

The firm will not issue any new common stock next year.
The firm’s total asset turnover ratio remains constant.