Your firm has $70 million in equity and $30 million in debt and forecasts $14 million in net income for the year. It currently pays dividends equal to 20% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 30% of net income. How would this change

Question

Your firm has $70 million in equity and $30 million in debt and forecasts $14 million in net income for the year. It currently pays dividends equal to 20% of its net income. You are analyzing a potential change in payout policy—an increase in dividends to 30% of net income. How would this change affect your internal and sustainable growth rates?

Accepted Answer

PLAN
We can use Eqs. 18.4 and 18.5 to compute your firm's internal and sustainable growth rates under the old and new policy. To do so, we’ll need to compute its ROA, ROE, and retention rate (plowback ratio). The company has $100 million (= $70 million in equity + $30 million in debt) in total assets

[latex] ext{Internal Growth Rate} = \left(\frac{ ext{Net Income}}{ ext{Beginning Assets}} ight) imes (1- ext{Payout Ratio}) = ROA imes ext{Retention Rate}[/latex] (18.4)

[latex] ext{Sustainable Growth Rate} = \left(\frac{ ext{Net Income}}{ ext{Beginning Equity}} ight) imes (1- ext{Payout Ratio}) = ROE imes ext{Retention Rate}[/latex] (18.5)

[latex] ROA = \frac{ ext{Net Income}}{ ext{Beginning Assets}}=\frac{14}{100}= 14\%[/latex] [latex] ROE = \frac{ ext{Net Income}}{ ext{Beginning Equity}}=\frac{14}{70}= 20\%[/latex]

Old Retention Rate = (1 – Payout Ratio ) = (1 – 0.20 ) = 0.80
New Retention Rate = (1 – 0.30 ) = 0.70

EXECUTE
Using Eq. 18.4 to compute the internal growth rate before and after the change, we have: Old Internal Growth Rate = ROA × Retention Rate = 14% × 0.80 = 11.2%
New Internal Growth Rate = 14% × 0.70 = 9.8%
Similarly, we can use Eq. 18.5 to compute the sustainable growth rate before and after: Old Sustainable Growth Rate = ROE × Retention Rate = 20% × 0.80 = 16%
New Sustainable Growth Rate = 20% × 0.70 = 14%

EVALUATE
By reducing the amount of retained earnings available to fund growth, an increase in the payout ratio necessarily reduces your firm’s internal and sustainable growth rates.

Question 18.3: Your firm has $70 million in equity and $30 million in debt ...

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