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Homework answers / question archive / Assume that an average firm in the office supply business has a 6% after-tax profit margin, a 40% debt/asset ratio, a total assets turnover of 2 times, and a dividend payout ratio of 40%
Assume that an average firm in the office supply business has a 6% after-tax profit margin, a 40% debt/asset ratio, a total assets turnover of 2 times, and a dividend payout ratio of 40%. Is it true that if such a firm is to have any sales growth, it will be forced either to borrow (take on debt) or sell common stock? Discuss.
Please see the attached file.
In order to find that out we need to calculate the Internal Growth Rate (IGR). IGR is the growth rate that a firm can have without resorting to any external financing - debt or equity.
IGR = ROA X b /(1-ROA x b)
Where
ROA = Return on Assets
b = Retention ratio = 1-dividend payout ratio
ROA = Net Income/Assets = Net Income/Sales X Sales /Assets
ROA = Profit Margin X Asset Turnover
Given that
Profit Margin = 6%
Assets Turnover = 2
ROA = 6%X2 = 12%
b = 1-0.4 = 0.6
IGR = 12% X 0.6 /(1-12%X0.6) = 7.76%
The firm can grow at 7.76% without any external financing. The statement is false.
We can verify it this way.
Existing Sales = 100
New Sales at IGR = 100X(1+7.76%) = 107.76
Net Income at 6% = 107.76X6%=6.4656
Retained Earnings = 6.4656X60%=3.88
The Asset Turnover is 2, so increase in assets will be ½ of the increase in sales.
Increase in assets = 7.76/2=3.88
This is matched by the retained earnings
So no new debt or equity is required.
