Lecture 2 Internal growth rate Vs. Sustainable growth rate

What’s the diff? Internal g: -No outside financing whatsoever -No new debt (  D = 0) -No new equity (  E = 0) -Capital budget depends on internally generated funds only Sustainable g: -No external equity financing (  E = 0) -Debt financing is ok in order to make D/E constant due to increase in retained earnings

Remember these formulas Internal g = (ROA x R) / [1 – (ROA x R)] Sustainable g = (ROE x R) / [1 – (ROE x R)] where ROA = NI/A (or the other Du Pont Identities) ROE = NI/E (or the other Du Pont Identities) R = 1 – (Dividends/NI) = 1 – Dividend payout ratio

Numerical Example Internal growth rate Information given: ROA = 1.5% R = 0.5 What is the internal growth rate (i.e., the growth rate that is possible without any new debt or equity)?

Numerical Example Sustainable growth rate Information given: ROE = 12% R = 0.7 What is the sustainable growth rate?

What about the Du Pont Identities? Ig = (ROA x R)/[1 – (ROA x R)]Sg = (ROE x R)/[1 – (ROE x R)] Variables: Ig ROA R Variables: Sg ROE R

Numerical Example Information given: Sg = 0.1 R = 0.6 Find ROE.

ROE = (NI/S) x (S/A) x (1 + D/E) Where NI/S = profit margin S/A = asset use efficiency D/E = debt-equity ratio What is we know the asset use efficiency, debt- equity ratio, retention ratio, and the sustainable growth rate. Can we find the profit margin?

Numerical Example Information given: Sg = 0.11 R = 0.5 S/A = 0.8 D/E = 1.5 What is ROE? What is profit margin?

Steps for figuring out unknown variables: 1.Write down all the available information on known variables. 2.Figure out what formulas are relevant. 3.Plug the known numbers into the relevant formulas. 4.Figure out which variable(s) is (are) missing. 5.Work backward to solve for the missing variable(s).

Be the boss of numbers and formulas Formulas are just tools Numbers are also just tools Make them dance for you