Custom Search

Internal and Sustainable Growth for Executive Fruit

Executive Fruit has chosen a plowback ratio of 1вБД3. Assume that equity outstanding at the start of the year is 600, and that outstanding assets at the start of the year are 1,000. Because net income during 1999 is 96, Executive Fruit`s return on equity4 is ROE = 96/600 = .16, and its ratio of equity to assets is 600/1,000 = .60. If it is unwilling to raise new capital, its maximum growth rate is

Internal growth rate = plowback ratio ROE equity assets

= 1 .16 .60 3 = .032, or 3.2%

This is much less than the 10 percent growth it projects, which explains its need for external financing.

3 Here is a proof.

Required equity issues = growth rate assets Ј retained earnings Ј new debt issues We find the sustainable growth rate by setting required new equity issues to zero and solving for growth: Sustainable growth rate = retained earnings + new debt issues assets = retained earnings + new debt issues debt + equity

However, because both debt and equity are growing at the same rate, new debt issues must equal retained earnings multiplied by the ratio of debt to equity, D/E. Therefore, we can write the sustainable growth rate as

Sustainable growth rate = retained earnings (1 + D/E) debt + equity = retained earnings (1 + D/E) = retained earnings equity (1 + D/E) equity = retained earnings net income = plowback ROE net income equity

4 Note that when we calculate internal or sustainable growth rates, ROE is properly measured by earnings as a proportion of equity at the start of the year rather than as a proportion of either end-of-year equity or the average of outstanding equity at the start and end of the year.

If Executive is prepared to maintain its current ratio of equity to total assets, it can issue an additional 40 cents of debt for every 60 cents of retained earnings. In this case, the maximum growth rate would be

Substainable growth rate = plowback ratio ROE = 1 .16 3 = .0533, or 5.33%

Executive`s planned growth rate of 10 percent requires not only new borrowing but an increase in the debt-equity ratio. In the long run the company will need to either issue new equity or cut back its rate of growth.5