Profit Margins and Sustainable Growth
The Sandar Co. has a debt equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40 percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10 percent sustainable growth rate and planned to achieve this goal by improving profit margins, what would you think?
ROE is .03×1 ×1.5 = 4.5 percent. The retention ratio is 1 .40 =.60. Sustainable growth is thus .045(.60)/[1 .045(.60)] = 2.77 percent. For the company to achieve a 10 percent growth rate, the profit margin will have to rise. To see this, assume that sustainable growth is equal to 10 percent and then solve for profit margin, PM:
.10 = PM(1.5)(.6)/[1 PM(1.5)(.6)]
PM =.1/.99 = 10.1%
For the plan to succeed, the necessary increase in profit margin is substantial, from 3 percent to about 10 percent. This may not be feasible.
C O N C E P T Q U E S T I O N S
a What are the determinants of growth?
b How is a firm’s sustainable growth related to its accounting return on equity (ROE)?