Introduction to Corporate Finance

PART 5: SPECIAL TOPICS

Finally, if the increases in assets must match the increase in the sum of liabilities and equity, then we

can write the following equations:

gA Sm gdSm gd

L

E

=+−+−











()() 11 ()+[()() 11 ()] 

↑assets ↑ret. earnings ↑liabilities

= +−











[(Sm)( gd)]1+ 

L

E

11 ()

↑(equity + liabilities)

The premise of the sustainable growth model is that there will be some rate of growth, g*, that keeps

the outflows and inflows of funds in balance. This is the sustainable growth rate. It can be found by

solving and rearranging the preceding equation and substituting A/E for (1 + L/E). It can be represented

as follows:

Eq. 16.1 (^) gg*
d
A
E
A
S
d
A
E
*=
−
−−
m
m
()
()
1
1
Notice how each of the key variables in Equation 16.1 affects the sustainable growth rate:
■ If a company’s net profit margin (m) increases, then the numerator rises and the denominator falls, so
g increases. Therefore, generating higher profits per dollar of sales provides fuel for a higher growth
rate.
■ Similarly, an increase in the ratio of assets to equity (A/E) – which can occur only if the company is
willing to accept greater financial leverage – also increases the sustainable growth rate. Companies
willing to borrow more can grow more rapidly.
■ If a company can increase its total asset turnover ratio (S/A), then the inverse ratio A/S falls and the
sustainable growth rate rises. Companies that manage assets more efficiently and generate higher
sales volume per dollar of assets can achieve more rapid growth.
■ Finally, a reduction in dividend payouts (d) also tends to increase g*. When companies retain more
earnings, they can finance faster growth.
■ This relates to the DuPont system discussed in Chapter 2.
example
In 2012, Virgin Australia Holdings Limited reported
the following preliminary financial data:
Sales $3,919.5 million
Net income $22.8 million
Total assets $3,995.2 million
Total equity $929.7 million
Dividends $0
From these figures, we can determine that Virgin
Australia’s net profit margin was 0.58%, its assets-
to-equity ratio was 4.30, its total asset turnover ratio
was 0.98 (which implies an assets-to-sales ratio of
1.02), and its dividend payout ratio was 0.0. Plugging
these values into Equation 16.1 yields a sustainable
growth rate of about 2.5%. This meant that the
company could increase sales by 2.5% without
issuing new ordinary shares and without changing
total asset turnover, dividend policy, profit margins
or leverage.
Source: Virgin Australia Holdings Limited: Preliminary Final Report for the year
ended 30 June 2012.
What are the financial
consequences of very rapid
growth?
thinking cap
question