Question

Donovan's would like to increase its internal rate of growth. Decreasing which one of the following will help the firm achieve its goal?A) Return on assetsB) Net incomeC) Retention ratioD) Dividend payout ratioE) Return on equity

Answer 1

Answer:

D) Dividend payout ratio

Explanation:

Internal Growth Rate of a firm is the maximum growth rate at which the firm can grow without involving external financing i.e. without assuming additional debt or equity infusion in the firm. At this level of growth the cash available from the operations can be used to fund the company.

It is calculated using the formula

IGR= ROA* b / (1-ROA * b)

where

IGR is the Internal Growth Rate

ROA is return on assets

b is the retention ratio or (1-dividend payout ratio)

To answer the question we look at each option

If ROA (Return on Asset) is decreased the numerator decreases and denominator increases in equation (1) and thus the Internal growth rate decreases, so ROA is not the answer

If Net Income is reduced the Return on Assets also falls thus as in the above case Internal growth Rate decreases

If retention ratio is reduced the numerator decreases and denominator increase leading to a fall in IGR

If dividend payout ratio is decreased the retention ratio increases leading to the increase in numerator and decrease in denomonator leading to an increase in the IGR. Thus Decreasing the dividend payout ratio will increase the IGR.

If Return on Equity is reduced i.e. indirectly Net Income is reduced for the same equity the similar effect as in part for Net Income and thus reduces the IGR.

So decreasing dividend payout ratio increases the interna growth rate of a firm