Introduction to Finance

FIGURE 18.5
Long-term Debt Divided by Total Assets

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C H A PT E R 1 8 Capital Structure and The Cost of Capital
This can also be calculated in the following way:
Internal growth rate (g) =
(RR)(ROA)
1 − (RR)(ROA)
(18-8)
RR is the fi rm’s retention rate, and ROA is its return on assets. The internal growth rate 
divides the product of these values by one minus this product.
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The 
retention rate
represents 
the proportion of every dollar of earnings per share that is retained by the fi rm; in other words, 
it is equal to one minus the 
dividend payout ratio
.
Suppose a fi rm pays out 40 percent of its earnings as dividends and has averaged a 
15 percent ROA for the past several years; how quickly can the fi rm grow without needing 
to tap outside fi nancing sources? A 40 percent dividend payout ratio means the fi rm’s reten-
tion rate is 1.00 – 0.40 = 0.60. Of every dollar of net income, the fi rm distributes $0.40 as 
dividends and retains $0.60. With a 15 percent ROA, equation 18-8 tells us the internal growth 
rate for the fi rm is the following: 
Internal growth rate =
(0.60)(0.15)
1 − (0.60)(0.15)
= 0.099 or 9.9 percent
If it relies only on new additions to retained earnings to fi nance asset acquisition and maintains 
its past profi tability and dividend payout, the fi rm can increase its asset base by a little less 
than 10 percent next year.
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The internal growth rate makes the restrictive assumption that the fi rm will pursue no 
outside fi nancing sources. Should the fi rm grow at its internal growth rate, its retained earn-
ings account will continually rise (assuming profi table sales) while its dollar amount of debt 
outstanding will remain constant. 
Thus, the relative amount of debt in its capital structure 
declines
over time and the debt level will likely fall below its proportion in management’s 
ideal fi nancing mix.
Sustainable Growth Rate
Perhaps a more realistic assumption would be to allow management to borrow funds over time 
to maintain steady capital structure ratios. As the stockholder’s equity account rises from new 
additions to retained earnings, the fi rm issues new debt to keep its debt to equity ratio constant 
over time.
This rate of growth is the