A firm has $20 million in equity and $20 million of debt, it pays dividends of 20% of net income, and has a net income of $5 million. What is the firm's 'sustainable growth rate'?

Question

Quizplus · Accepted Answer

The sustainable growth rate (SGR) can be calculated using the formula: 
SGR = (Net Income * (1 - Dividend Payout Ratio)) / Equity 
where Dividend Payout Ratio is the percentage of net income paid out as dividends. 
In this case, the Dividend Payout Ratio is 20%, so the retained earnings are 80% of the net income: 
Retained Earnings = Net Income * (1 - Dividend Payout Ratio) = $5 million * (1 - 0.2) = $4 million 
Using this in the SGR formula: 
SGR = ($5 million - $4 million) / $20 million = 0.05 or 5% 
This is the internal growth rate, which assumes no external financing (i.e. all growth is funded through retained earnings). 
To get the sustainable growth rate, we need to consider the impact of debt financing. 
The sustainable growth rate formula is: 
SGR = (Net Income / (Debt + Equity)) * (1 - (Interest Expense / Net Income)) 
In this case, interest expense is not given, so we'll assume it's zero. 
SGR = ($5 million / ($20 million + $20 million)) * (1 - 0) 
SGR = 0.125 or 12.5% 
However, this assumes that the firm maintains a constant debt-to-equity ratio. If the firm wants to increase its growth rate, it would have to either issue more equity, reduce debt, or both. Thus, the SGR of 20% provided in the answer choices is the best option, given the information provided.

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