“If a firm keeps its capital structure and return on equity constant over time, then to grow faster than the sustainable growth rate it must issue additional common stock.” (referenced in CFAI reading 41 Q. 23) g = b * ROE b = retention ratio, g= sustainable growth rate The above statement is true, but it is not entirely clear to me why this is so. If someone could please shed light on this, that would be much appreciated. Not sure if the sustainable growth rate formula is applicable in the explanation, but I’ve added it above for reference anyway. Thanks
Remember that the *sustainable growth rate* g = ROE*RR assumes that there are no external equity infusions and that the capital structure remains constant. The firm can grow by issuing new stock (perhaps also taking on debt in order to keep the capital structure constant.) It can use the funds from the additional common stock to increase the retention ratio, for example. It always helps me to think of an example. A company has 100 shares of stock and it pays a $1 dividend. It has an ROE of 10% and b = 50%, so g = 5%. Now it issues another 100 shares of stock. Say it raises $500 this way. It has to pay out $200 in dividends ($1 per share, but there are now 200 shares), but it can keep the other $300 for reinvestment. If it hadn’t issued shares, it would have had to pay the dividends out of net income. Since it was able to increase the retention ratio above 50%, (300/500 raised is reinvested > 50%) the growth g increases… but g is all about “SUSTAINABLE growth” for the long term. The increase might be temporary as it would have to continue issuing stock to keep this up. HTH
if a firm issues common stock, wouldn’t this increase equity, decrease ROE and decrease g? does that get us anywhere?
No, the assumptions of sustainable growth rate are “no external equity financing”, the firm just operates on the base of equity it has and holds this forever.