A firm expects growth next year to be 12%. Its sustainable growth rate is 10%. Which of the following is true?
A) The firm will need to raise additional debt such that its debt to equity ratio will increase.
B) The firm may be able to keep its debt to equity ratio the same by reducing dividends (assuming they are projected to be high enough).
C) The firm will need to raise additional capital through a stock issue.
D) The firm will have excess cash to increase dividends, pay back debt, or repurchase equity.

Question

Quizplus · Accepted Answer

The sustainable growth rate is the maximum rate at which a firm can grow without having to increase its debt-to-equity ratio. If a firm expects growth next year to be higher than its sustainable growth rate, it will need additional financing to support that growth.

Option A is incorrect because raising additional debt would increase the debt-to-equity ratio, which is not desirable if the firm wants to maintain a stable capital structure.

Option C is also incorrect because raising capital through a stock issue would dilute the ownership of existing shareholders, which may not be necessary if the firm can reduce dividend payments to retain earnings.

Option D is incorrect because if the firm has excess cash, it can use it to pay down debt or repurchase equity, but it may not have sufficient cash to do so if it needs financing for growth.

Therefore, the best choice is B, which suggests that the firm may be able to keep its debt-to-equity ratio the same by reducing dividends (assuming they are projected to be high enough). This would allow the firm to retain earnings and reinvest them in the business to support its growth.

A Firm Expects Growth Next Year to Be 12