Question

As a firm grows, it must support increases in revenue with new investments in assets. The self-supporting 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 this case: Fuzzy Button Clothing Company has no debt in its capital structure and has $300 million in assets. Its sales revenues last year were $150 million with a net income of $10 million. The company distributed $1.05 million as dividends to its shareholders last year. What is the firm’s self-supporting, growth rate? (Note: Do not round your intermediate calculations.) A. 0.35% B. 3.08% C. 3.82% D. 1.36% Which of the following are assumptions of the self-supporting growth model? Check all that apply. A. The firm maintains a constant ratio of assets to equity. B. The firm maintains a constant net profit margin. C. The firm uses all equity and no debt financing. D. Common stock is the firm’s only form of equity.

Answer 1

a. 5.37%

b. Option A

Step-by-step explanation:

a). ROE = (Sales / Total Assets) *(Net income / Sales) * (Assets/ Equity)

= ($90,000,000 / $150,000,000) * ($10,000,000 / $90,000,000) = 0.0667, or 6.67%

Dividend Rate = Dividend / Net Income = $1,950,000 / $10,000,000 = 0.195, or 19.50%

Retention ratio = (1 - Dividend rate) = 1 - 0.195 = 0.805, or 80.50%

Sustainable growth rate = ROE * Earnings retention ratio

= 6.67% * 0.805 = 5.37%

b). Option "A" is correct.

To maintain a sustainable growth model, one of the assumptions of the model is that proportion of sales and assets remains stable.

Other assumptions are, the firm should maintain a constant net profit margin in proportion to sales achieved, and the capital structure and dividend pay out ratio remains the same.