A firm has $20 million in equity and $10 million in debt.The firm forecasts that this year's net income will be $2.5 million.It currently pays dividends equal to 30% of its net income.If the firm decides to change its payout policy to 40% of net income,how would this change its internal growth rate?

Question

Quizplus · Accepted Answer

The internal growth rate is the maximum rate of growth a firm can achieve without issuing new equity or debt. It is calculated as (ROA x b) / (1 - ROA x b), where ROA is the return on assets and b is the retention ratio (the proportion of earnings not paid out as dividends).

The current ROA of the firm is 2.5 million / 30% / 20 million = 4.17%. The current retention ratio is 1 - 30% = 70%.

If the payout policy is changed to 40%, the new retention ratio will be 1 - 40% = 60%. The new ROA will be 2.5 million / 40% / 20 million = 6.25%.

Plugging these values into the formula, the new internal growth rate is (6.25% x 60%) / (1 - 6.25% x 60%) = 7.76%.

The old internal growth rate was (4.17% x 70%) / (1 - 4.17% x 70%) = 5.00%.

Therefore, the change in payout policy reduces the internal growth rate by 1.76 percentage points, or 0.83%. The answer is A.

A Firm Has $20 Million in Equity and $10 Million