Introduction to Finance

sustainable growth rate
. It measures how quickly the fi rm can grow 
when it uses internal equity and debt fi nancing to keep its capital structure constant over time.
The sustainable growth rate is computed as follows:
Sustainable growth rate =
(RR)(ROE)
1 − (RR)(ROE)
The fi rm’s retention rate (RR) is multiplied by its return on equity (ROE), divided by one 
minus this product.
12
retention rate 
the proportion of 
each dollar of earnings per share 
that is retained by the fi rm
dividend payout ratio 
the 
proportion of each dollar of 
earnings that is paid to shareholders 
as a dividend; equals one minus the 
retention rate
sustainable growth rate 
the 
estimate of how quickly a fi rm can 
grow when it uses internal equity 
and debt fi nancing to keep its 
capital structure constant over time
10
An end-of-chapter problem (Problem 13) invites you to derive this relationship.
11
Most managers plan and think in terms of sales dollars rather than size, so it may help to relate the internal growth 
rate to sales growth. If the fi rm’s total asset turnover ratio is expected to remain constant into the foreseeable future, 
the growth in sales will equal the internal growth rate computed above. For example, suppose the total asset turnover 
ratio of 2.0 is expected to remain constant over the next few years: 
Sales
TA
= 2.0
Sales and assets will rise at their respective growth rates:
Sales (1 +
g
s
)
TA (1 +
g
a
)
= 2.0
Then
2.0 =
(Sales)(1 +
g
s
)
(TA)(1 +
g
a
)
= 2.0
(1 +
g
s
)
(1 +
g
a
)
This implies that 1 + 
g
s
= 1 + 
g
a
, or that sales growth will equal asset growth.
12
You have a chance to derive this relationship in one of the end-of-chapter problems (Problem 14).

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18.5 Planning Growth Rates
581
Suppose the fi rm in the prior example maintains a debt to equity ratio of 1.0 (which is 
equivalent to an equity multiplier of 2.0) to minimize its fi nancing costs. What would be the 
fi rm’s sustainable growth rate? From the discussion in Chapter 14 analyzing DuPont, we know 
that ROE = ROA × equity multiplier.
Since the fi rm has an ROA of 15 percent, its ROE equals 15 percent × 2 = 30 percent; 
with an RR of 0.60, the sustainable growth rate equals the following:
Sustainable growth rate =
(0.60)(0.30)
1 − (0.60)(0.30)
= 0.2195 or 21.95 percent
Thus, without outside fi nancing, the fi rm can increase sales and assets by less than 10 percent; 
by maintaining a constant capital structure, the fi rm can grow by nearly 22 percent if it can 
maintain its levels of profi tability and earnings retention.
Eff ects of Unexpectedly Higher (or Lower) Growth
The internal and sustainable growth rates are planning tools. These formulas cannot make 
a fi rm grow by a certain prescribed amount. Changing global competition and political and 
credit market conditions can cause growth to deviate from planned growth.
The internal and sustainable growth rate relationships suggest three measurable infl u-
ences impacting growth: dividend policy (as refl ected in the retention rate), profi tability (as 
measured by ROA), and the fi rm’s capital structure (as measured by the equity multiplier). A 
fourth infl uence that is harder to measure is management’s preferences and beliefs about using 
external fi nancing rather than relying solely on changes in retained earnings. Should actual 
growth diff er from planned growth, one or more of these factors will have to be adjusted to 
prevent fi nancial diffi
culty or to absorb excess funds.