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 Fuzzy Button Clothing Company:

Fuzzy Button Clothing Company has no debt in its capital structure and has $300,000,000 in assets. Its sales revenues last year were $150,000,000 with a net income of $5,000,000. The company distributed $105,000 as dividends to its shareholders last year.

Given the information above, what is Fuzzy Button Clothing Company’s sustainable growth rate?

1.66%

2.7318006%

0.7314494%

0.0349772%

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 maintains a constant ratio of assets to equity.

C. Common stock is the firm’s only form of equity.

D. The firm uses all equity and no debt financing.

Answer 1

Sustainable growth rate= ROE*b/(1-ROE*b)

Where

ROE= Return on Equity= Net Income/Equity.

Since there is no debt, Equity= Assets= $300,000,000

b= Plowback ratio= 1-(Dividend/Net income)

Given,

Net income= $5,000,000

Dividend= $105,000

Plugging the values,

ROE= 5,000,000/300,000,000= 0.016667

Plowback ratio= 1-105,000/5,000,000 = 0.979

Sustainable growth rate= 0.016667*0.979/(1-0.016667*0.979) = 1.66% (rounded)

Answer is the first choice given.

The following, among the choices given, are assumptions of the sustainable (self-supporting) growth model:

A. The firm maintains a constant net profit margin.

B. The firm maintains a constant ratio of assets to equity.

Regarding others which are not correct:

There is no assumption of zero debt. The assumption is that the capital structure shall be constant.