# The two growth rates internal and sustainable are

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Unformatted text preview: margins, increase total asset turnover, increase financial leverage, increase earnings retention, or sell new shares. The two growth rates, internal and sustainable, are summarized in Table 3.18. A Note on Sustainable Growth Rate Calculations Very commonly, the sustainable growth rate is calculated using just the numerator in our expression, ROE b. This causes some confusion, which we can clear up here. The issue has to do with how ROE is computed. Recall that ROE is calculated as net income divided by total equity. If total equity is taken from an ending balance sheet (as we have done consistently, and is commonly done in practice), then our formula is the right one. However, if total equity is from the beginning of the period, then the simpler formula is the correct one. In principle, you’ll get exactly the same sustainable growth rate regardless of which way you calculate it (as long as you match up the ROE calculation with the right formula). In reality, you may see some differences because of accounting-related complications. By the way, if you use the average of beginning and ending equity (as some advocate), yet another formula is needed. Also, all of our comments here apply to the internal growth rate as well. TABL E 3 .1 8 Summary of Internal and Sustainable Growth Rates I. Internal Growth Rate Internal growth rate ROA b ___________ 1 ROA b where ROA Return on assets Net income Total assets b Plowback (retention) ratio Addition to retained earnings Net income The internal growth rate is the maximum growth rate than can be achieved with no external financing of any kind. II. Sustainable Growth Rate Sustainable growth rate ROE b ___________ 1 ROE b where ROE Return on equity Net income Total equity b Plowback (retention) ratio Addition to retained earnings Net income The sustainable growth rate is the maximum growth rate that can be achieved with no external equity financing while maintaining a constant debt-equity ratio. 78 PART 1 Overview ros82361_ch03.indd ros82361_ch03.indd 78 7/7/08 3:59:08 PM Confirming Pages 3 . 7 S O M E C A V E AT S R E G A R D I N G F I N A N C I A L PLANNING MODELS Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out, namely, cash flow size, risk, and timing. Because of this, financial planning models sometimes do not produce output that gives the user many meaningful clues about what strategies will lead to increases in value. Instead, they divert the user’s attention to questions concerning the association of, say, the debt-equity ratio and firm growth. The financial model we used for the Hoffman Company was simple—in fact, too simple. Our model, like many in use today, is really an accounting statement generator at heart. Such models are useful for pointing out inconsistencies and reminding us of financial needs, but they offer very little guidance concerning what t...
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