Broslofski Co. maintains a positive retention ratio and keeps its debt-equity ratio constant every year. When sales grow by 20 %, the firm has a negative projected EFN. What does this tell you about the firm's sustainable growth rate? Do you know, with certainty, if the internal growth rate is grater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What if the retention ration is decreased? What if the retention ratio is zero?
The sustainable growth rate is greater than 20%, because at a 20% growth rate the negative EFN indicates that there is excess financing still available. If the firm is 100% equity financed, then the sustainable and internal growth rates are equal and the internal growth rate would be greater than 20%. However, when the firm has some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether the internal growth rate would be greater than or less than 20%. If the retention ratio is increased, the firm will have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets.