Chapter 4 - Answers to Concepts Review and Critical Thinking Questions
The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets,
employees, and, in fact, just about every aspect of its operations and financing exist to directly or
indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees,
inventory, and financing are determined by its future sales level.
Two assumptions of the sustainable growth formula are that the company does not want to sell new
equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt-
equity ratio it can grow at a higher rate than the sustainable growth rate. Of course the company could
also grow faster than its profit margin increases, if it changes its dividend policy by increasing the
retention ratio, or its total asset turnover increases.
The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN
indicates that there is excess internal financing. If the internal growth rate is greater than
15%, then the sustainable growth rate is certainly greater than 15%, because there is
additional debt financing used in that case (assuming the firm is not 100% equity-financed).
As the retention ratio is increased, the firm has more internal sources of funding, so the EFN
will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm
pays out all its earnings in the form of dividends, then the firm has no internal sources of
funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case
and the EFN will rise to the change in total assets.
The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative
EFN indicates that there is excess financing still available. If the firm is 100% equity
financed, then the sustainable and internal growth rates are equal and the internal growth rate
would be greater than 20%. However, when the firm has some debt, the internal growth rate
is always less than the sustainable growth rate, so it is ambiguous whether the internal growth
rate would be greater than or less than 20%. If the retention ratio is increased, the firm will
have more internal funding sources available, and it will have to take on more debt to keep
the debt/equity ratio constant, so the EFN will decline. Conversely, if the retention ratio is
decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable
growth rates are zero, and the EFN will rise to the change in total assets.
Presumably not, but, of course, if the product had been
less popular, then a similar fate would
have awaited due to lack of sales.