Example

Profit Margins and Sustainable Growth

The Sandar Co. has a debt-equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40 percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10 percent sustainable growth rate and planned to achieve this goal by improving profit margins, what would you think?

ROE is .03 X 1 X 1.5 = 4.5 percent. The retention ratio is 1 - .40 = .60. Sustainable growth is thus .045(.60)/[1 - .045(.60)] = 2.77 percent.

For the company to achieve a 10 percent growth rate, the profit margin will have to rise. To see this, assume that sustainable growth is equal to 10 percent and then solve for profit margin, PM:

For the plan to succeed, the necessary increase in profit margin is substantial, from 3 percent to about 10 percent. This may not be feasible.

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