Question

17-2. Assume that an average firm in the office supply business has a 6% profit margin, a 40% total liabilities/assets ratio, a total assets turnover of 2 times, and a dividend payout ratio of 40%. Is it true that if such a firm is to have any sales growth (g > 0), it will be forced to borrow or to sell common stock (that is, it will need some nonspontaneous external capital even if g is very small)? Explain.

Answer 1

Answer:

No it will not, the statement is incorrect.

Explanation:

if the firm is making a profit, then it means it is growing, so we must determine the firm's growth rate:

firm's growth rate = return on assets (ROA) x (1 - dividends paid)

since we are not given ROA, we must calculate it first:

ROA = net profit x asset turnover =  6% x 2 = 12%

now we go back, firm's growth rate = return on assets (ROA) x (1 - dividends paid) = 12% x (1 - 40%) = 12% x 0.6 = 7.2%

The firm can manage to support an annual growth rate of up to 7.2% before it needs to borrow money or issue new stocks.