Question

Suppose a firm maintains a positive retention ratio and keeps its debt-equity ratio constant every year. When sales grow by 20%, the firm has a negative projected EFN.
a) Can you tell, with certainty, that the sustainable growth rate is greater than/equal to/ less than 20%? Why/Why not?
b) Do you know with certainty that the internal growth rate is greater than/equal to/ less than 20%? Why/Why not?

Answer 1

a)

The sustainable growth rate is greater than 20%. This is because even at 20% growth rate, negative project EFN portrays that excess funding is still available for the firm. In short, there is still excess internal financing suggesting that the sustainable growth rate is greater than 20%.

b)

The sustainable growth rate in this case is greater than 20%. The internal growth rate is always lesser than the sustainable growth rate when the firm has any equity finance lesser than 100%, ie. the firm has some debt. Only if the firm is 100% equity financed, the sustainable growth rate and the internal growth rate are equal.

Here, we cannot be able to say with certainty about the internal growth rate whether it would be greater than, equal to or lesser than 20%.