Sustainable growth. A firm has decided that its optimal capital structure is 100 percent equity financed. It perceives its optimal dividend policy to be a 40 percent payout ratio. Asset turnover is sales/assets - .8, the profit margin is 10 percent, and the firm has a target growth rate of 5 percent.
1. Is the firm's target growth rate consistent with its other goals?
2. If not, by how much does it need to increase asset turnover to achieve its goals?
3. How much would it need to increase the profit margin instead?
To solve the problem, we can arbitrarily assign a value for sales. Any value will work so long as we are consistent using the percentages and ratios given. For ease of use, let's use $1,000,000 in 1st year sales.
Year 1 Year 2
Sales $1,000,000 $1,050,000 (5% growth)
Profit (10%) $100,000 $105,000
Dividends (40%) $40,000 $42,000
Retained Earnings $60,000 $63,000
Since we know the asset turnover ...
The solution considers a firm's desired capital structure and balances it against its futuer growth plans in an effort to make recommendations that will satisfy both requirements.