Question

Use the below information to answer the following question.

Income Statement
For the Year
Sales $28,400
Cost of goods sold 21,200
Depreciation 2,700

Earnings before interest and taxes $ 4,500
Interest paid 850

Taxable income $ 3,650
Taxes 1,400

Net income $ 2,250

Dividends $900


Balance Sheet
End-of-Year
Cash $ 550
Accounts receivable 2,450
Inventory 4,700

Total current assets $ 7,700
Net fixed assets 16,900

Total assets $24,600

Accounts payable $ 2,700
Long-term debt 9,800
Common stock ($1 par value) 8,000
Retained earnings 4,100

Total Liab. & Equity $24,600


If this firm decides to maintain a constant debt-equity ratio, what rate of growth can it maintain, assuming that no additional external equity financing is available.

Answer 1

The firm can maintain an 11.16% rate of growth while keeping a constant debt-equity ratio without external equity financing. This is calculated using the sustainable growth rate formula, which involves the retention ratio and return on equity.

Step-by-step explanation:

To determine the rate of growth a firm can maintain while keeping a constant debt-equity ratio without external equity financing, we use the concept of sustainable growth rate (SGR). The sustainable growth rate is the maximum rate of growth a firm can sustain without increasing financial leverage. It can be calculated using the formula:

SGR = Retention Ratio x Return on Equity (ROE)

Where Retention Ratio is the portion of net income that is not paid out as dividends, and Return on Equity is net income divided by equity. In this case, the retention ratio is:

(Net income - Dividends) / Net income = ($2,250 - $900) / $2,250 = 0.6

And the ROE is:

Net income / Equity = $2,250 / ($8,000 + $4,100) = $2,250 / $12,100 = 0.186

Thus, the SGR is:

0.6 x 0.186 = 0.1116 or 11.16%

This implies that the firm can maintain a growth rate of 11.16% with its current operations and dividend policy, as long as it does not increase its debt-equity ratio.