If a firm keeps its capital structure and ROE is constant over time, then to grow faster than the sustainable growth rate it must issue additional common stock. True or false? and why?
I’ll bite. I’m going to say False. They could adjust their retention ratio.
SGR = ROE*B if roe is constant, only the changes in dividend payout ratio or the plowback ratio will affect it.
pacmandefense Wrote: ------------------------------------------------------- > SGR = ROE*B > > if roe is constant, only the changes in dividend > payout ratio or the plowback ratio will affect it. If you read OP’s question really carefully though, it ask in order to push growth beyond SCR… that means changing the plowback with not increase growth above SCR because it would be the SCR going up. So in order to growth faster than SCR, you need financing growth. I am probably dead wrong here and I haven’t started studying yet 
actually the cfai says this is true. but do not really understand their logic behind it…
I guess if you change your retention rate, then you’ve also changed your SGR, so you’re still growing at the SGR… So I guess it’s true that you need to issue additional common stock… What do you think?
given that ROE is constant, the only way g can be increased is through retention ratio. Using residual dividend policy (big assumption; i know) retention ratio can be increased if you have higher capital base than before to take care of the projects at hand. given this question though at first i would have said false though…
If you issue more common stock, doesnt this change your capital structure? So you wouldnt be keeping the capital structure constant. I would have said false too
Assuming of course that you issue more debt. Note, unless you pay out all earnings as dividends, you’ll always have to issue more debt, so that equity vs debt is balanced.
So i guess if you change your retention ratio, you would be changing you capital structure as well…
why would retention ratio change your capital structure. Retention ratio is amount of the Earnings you do not want to distribute as dividends. I am seriously missing something here.
I don’t think that changing your retention rate will always lead to a change in capital structure. Just think of a quarter where earnings are abnormally high… if the company only pays out a portion of this increase it will be changing its retention rate, but no change in capital structure. If you use the extra money to pay off debt, then yes, but that’s not always the case.
If you want to preserve your capital structure, and are retaining any earnings at all, then you’ll have to issue some debt every year. My interpretation of the question is that the firm will issue debt as needed to keep the target capital structure. Otherwise it will deviate from it. However, to grow faster than SGR, it also has to issue stock, otherwise it will have too large a proportion of debt.
naze_duck Wrote: ------------------------------------------------------- > If you want to preserve your capital structure, > and are retaining any earnings at all, then you’ll > have to issue some debt every year. Why? What if earnings are greater than the proposed dividend?
OK, maybe I’m missing something here. Let’s say you have 100 debt, 100 equity, and your target is 50% E and 50% Debt. Now you earn 100, and you retain it all. Haven’t you deviated from your 50 / 50 structure? Wouldn’t you need to issue another 100 in debt? Correct me if I’m wrong…
When did the CFAI go to a True/False question format?
naze_duck Wrote: ------------------------------------------------------- > OK, maybe I’m missing something here. > > Let’s say you have 100 debt, 100 equity, and your > target is 50% E and 50% Debt. > > Now you earn 100, and you retain it all. Haven’t > you deviated from your 50 / 50 structure? Wouldn’t > you need to issue another 100 in debt? > > Correct me if I’m wrong… Now that makes sense. Well played…
PS By its mere construction this has to be false because a capital structure cannot stay fixed when you are told that the company is issuing common stock (this causes the CS to change), unless you make the additional assumption that debt increase in line with equity to keep CS the same. However, you are told nothing about debt and cannot assume anything additional about debt outside what the question tells you. This question is false without further info!
Then again, you _have_ to issue debt to keep the target structure anyway - unless your retained earnings are zero. So it seems like a safe bet to assume that the company will issue debt…
Yes to keep the CS constant the company must issue debt, however, this is not a “safe” assumption is my opinion since you are making it completely outside the framework of the question, whereas you are told that common stock will be issued.