Question

Alberto's Co. maintains a positive retention ratio and maintains a constant debt-equity ratio every year. When sales grew 20 percent, the company had a negative projection EFN. What does this tell us about the company's sustainable growth rate? Do you know, for sure, if the internal growth rate is more than or less than 20 percent? Why ? What happens to the projected EFN if the retention rate increases? What if the retention rate is lowered? What if the retention rate is zero?

Answer 1

The sustainable growth rate is greater than 20% because when the EFN growth rate is 20%, it indicates that there are still funds available. If the company uses 100% equity financing, the sustainable growth rate and the internal growth rate will be equal, and the internal growth rate will be greater than 20%.

However, when a company has debt, the internal growth rate is always less than the sustainable growth rate, so it is always ambiguous whether the internal growth rate is greater than or less than 20%.

If the retention rate increases, the company will have more internal sources of funds available, and it will have to assume more debt to keep the debt-to-equity ratio unchanged, so EFN will fall.

Conversely, if the retention rate decreases, the EFN will increase. If the retention rate is zero, the internal growth rate and the sustainable growth rate are both zero, and EFN will rise to the change in total assets.