In the chapter, we used Rosengarten Corporation to demonstrate how to calculate EFN. The ROE for Rosengarten is about 7.3 percent, and the plowback ratio is about 67 percent. If you calculate the sustainable growth rate for Rosengarten, you will find it is only 5.14 percent. In our calculation for EFN, we used a growth rate of 25 percent. Is this possible

Explanation:

Sustainable Growth:

The maximum growth rate a firm can achieve with no external equity financing while maintaining  a constant debt-equity ratio is known as Sustainable Growth Rate. It is the maximum rate of  growth a firm can maintain without increasing its financial leverage.

The formula for finding out the sustainable growth rate is:

Where

ROE — Retum On Equity

b — plowback or retention ratio

ROE is the product of profit margin, total asset turnover and equity multiptier.

External Financing Needed (EFN) is the increase in assets minus the addition to retained

earnings.

EFN = Increase in assets - Addition to retained earnings

The increase in assets is the product of the beginning assets and the growth rate.

Increase in assets = Beginning assets x growth rate

The addition to the retained earnings next year is the product of current net income and the

retention ratio and one plus growth rate.

Addition to retained earnings = Current net income x retention ratio x(1+ growth rate)

The ROE of Rosengarten Corporation is 7.3%, plowback ratio is 67%. Then, the sustainable  growth rate is 5.14% only. The question is whether a growth rate of 25% can be used to calculate  the EFN (External Funds Needed).

The growth rate of 25% can be used to calculate the EFN. The sustainable growth rate formula is

based on two assumptions that the company does not want to sell new equity, and that the  financial policy is fixed. If the company rises outside equity, or increases its debt-equity ratio. it  can grow at a higher rate than the sustainable growth rate.

A firm's ability to sustain growth depends on the following four factors:

1. Profit Margin: An increase in profit margin will increase the firm's ability to generate funds

internally and thereby increase its sustainable growth.

2. Dividend policy: A decrease in the percentage of net income paid out as dividends will

increase the retention ratio. This increase internally generated equity and thus increases

sustainable growth.

3. Financial policy: An increase in the debt-equity ratio increases the firm’s financial leverage.

Since this makes additional debt financing available, it increases the sustainable growth rate.

4. Total asset turnover: An increase in the firm's total asset turnover increases the sales  generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow  and thereby increases the sustainable growth rate. The increasing total asset turnover is the

same as decreasing capital intensity.

The sustainable growth rate illustrates the explicit relationship between the firm's four major  areas; its operating efficiency as measured by profit margin, its asset use efficiency as measured  by total asset turnover, its dividend policy as measured by the retention ratio, and its financial  policy as measured by the debt-equity ratio.

Thus, the company could also grow faster when its profit margin increases, it it changes its dividend policy, by increasing the retention ratio or by increasing its total asset turnover.