Corporate Finance Quiz: Sustainable Growth Rate
20 questions · exam conditions
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Sustainable Growth RateQuestion 1 of 20

A stable, mature company adheres to a policy of paying out 40% of its earnings as dividends and maintains a constant debt-to-equity ratio. The company's return on equity (ROE) is consistently 15%. Assuming these policies continue, what is the expected long-term growth rate of its dividends per share?

6.0%
15.0%
9.0%
25.0%
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Corporate Finance Quiz

Corporate Finance Quiz: Sustainable Growth Rate

Practice Sustainable Growth Rate in Corporate Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Sustainable Growth Rate, giving you a quick way to practice the rules, question types, and explanations that matter most for Corporate Finance.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A stable, mature company adheres to a policy of paying out 40% of its earnings as dividends and maintains a constant debt-to-equity ratio. The company's return on equity (ROE) is consistently 15%. Assuming these policies continue, what is the expected long-term growth rate of its dividends per share?

  1. 6.0%
  2. 15.0%
  3. 9.0% (correct answer)
  4. 25.0%
Explanation: For a firm with a constant dividend payout ratio, the growth rate of dividends per share will be equal to the growth rate of earnings per share. The sustainable growth rate (SGR) represents the rate at which earnings can grow while maintaining constant financial policies (profitability, dividend policy, and leverage). Therefore, the expected long-term dividend growth rate is the SGR.
  1. Retention ratio (b) = 1 - 0.40 = 0.60.
  2. SGR = ROE × b = 15% × 0.60 = 9.0%.

Question 2

A firm has a net profit margin of 8%, asset turnover of 1.5, and a debt-to-equity ratio of 0.5. Its dividend payout ratio is 40%. The firm plans to change its capital structure by increasing its debt-to-equity ratio to 1.0. Assuming profitability and asset turnover remain unchanged, what will be the new sustainable growth rate?

  1. 10.8%
  2. 24.0%
  3. 9.6%
  4. 14.4% (correct answer)
Explanation: This problem uses the DuPont framework to see how a change in leverage affects SGR. \n1. Calculate the retention ratio (b), which is constant: b=1−0.40=0.60b = 1 - 0.40 = 0.60. \n2. Find the old Equity Multiplier (EM): EMold=1+D/E=1+0.5=1.5EM_{old} = 1 + D/E = 1 + 0.5 = 1.5. \n3. Find the new Equity Multiplier: EMnew=1+D/E=1+1.0=2.0EM_{new} = 1 + D/E = 1 + 1.0 = 2.0. \n4. Calculate the new ROE using the DuPont identity: ROEnew=Profit Margin×Asset Turnover×EMnew=8%×1.5×2.0=24%ROE_{new} = \text{Profit Margin} \times \text{Asset Turnover} \times EM_{new} = 8\% \times 1.5 \times 2.0 = 24\%. \n5. Calculate the new SGR: SGRnew=ROEnew×b=24%×0.60=14.4%SGR_{new} = ROE_{new} \times b = 24\% \times 0.60 = 14.4\%.

Question 3

The sustainable growth rate (SGR) model is most reliable as a forward-looking tool when which of the following underlying assumptions about the firm's future policies are expected to hold true?

  1. The firm will issue new equity to fund all of its attractive investment projects.
  2. The firm will maintain a constant debt-to-equity ratio and dividend payout ratio. (correct answer)
  3. The firm's return on assets and dividend payout ratio are expected to steadily increase.
  4. The firm will prioritize debt reduction over both dividends and reinvestment.
Explanation: The SGR model is built on a foundation of stable financial policies. The key assumptions are that the firm will maintain a constant capital structure (i.e., a constant debt-to-equity ratio), a constant dividend payout ratio (which implies a constant retention ratio), and stable profitability (constant ROE). If these ratios are not held constant, the calculated SGR will not be an accurate measure of sustainable growth.

Question 4

A firm reports net income of $100 million. Its balance sheet shows total common equity of $500 million and preferred stock of $100 million. The firm paid $8 million in preferred dividends and $36.8 million in common dividends during the year. What is its sustainable growth rate?

  1. 11.04% (correct answer)
  2. 9.20%
  3. 11.63%
  4. 7.36%
Explanation: SGR should be calculated based on the returns and retention available to common shareholders.
  1. Calculate Earnings Available to Common: Net Income - Preferred Dividends = $100M - $8M = $92M.
  2. Calculate Return on Common Equity (ROCE): Earnings Available to Common / Common Equity = $92M / 500M=18.4500M = 18.4%. \n3. Calculate Retention Ratio (b) for common shareholders: b = (Earnings Available to Common - Common Dividends) / Earnings Available to Common = (92M - $36.8M) / $92M = $55.2M / $92M = 0.60. \n4. Calculate SGR: SGR = ROCE × b = 18.4% × 0.60 = 11.04%.

Question 5

A company has a return on assets (ROA) of 10%, a return on equity (ROE) of 18%, and a dividend payout ratio of 40%. The company's management wants to identify the maximum growth rate possible without issuing any new equity, while maintaining a constant debt-to-equity ratio. What is this growth rate?

  1. 10.8% (correct answer)
  2. 6.0%
  3. 7.2%
  4. 4.0%
Explanation: The question is asking for the definition of the sustainable growth rate (SGR): the maximum growth rate without new external equity financing while maintaining a constant debt-to-equity ratio. \n1. Calculate the retention ratio (b): b=1−payout ratio=1−0.40=0.60b = 1 - \text{payout ratio} = 1 - 0.40 = 0.60. \n2. Calculate the SGR: SGR=ROE×b=18%×0.60=10.8%SGR = ROE \times b = 18\% \times 0.60 = 10.8\%. \nThe ROA information is a distractor, designed to tempt test-takers into calculating the internal growth rate.

Question 6

For the past three years, a company has achieved an actual sales growth rate of 15% annually. An analyst calculates that the company's sustainable growth rate over the same period was consistently around 11%. Which of the following is the most plausible explanation for this discrepancy?

  1. The company's dividend payout ratio has been increasing each year.
  2. The company's net profit margin has been in decline.
  3. The company has been steadily increasing its financial leverage. (correct answer)
  4. The company has maintained a constant debt-to-equity ratio.
Explanation: When actual growth exceeds the sustainable growth rate (SGR), it means the firm is growing faster than it can support with just retained earnings and a proportional increase in debt. This implies that one of the SGR's underlying assumptions is being violated. A steady increase in financial leverage (debt-to-equity ratio) would increase ROE each year, allowing the firm to support a higher growth rate than the SGR calculated using a constant leverage assumption.

Question 7

A company reports the following information for the year: Sales = $500M, EBIT = $80M, Interest Expense = $10M, Tax Rate = 25%, Total Assets = $400M, Total Debt = $150M. The company paid $21M in dividends. What is the company's sustainable growth rate?

  1. 16.0%
  2. 8.1%
  3. 12.6% (correct answer)
  4. 21.0%
Explanation: This requires calculating SGR from raw financial data. 1. Calculate Net Income (NI): EBT = EBIT - Interest = $80M - $10M = $70M. NI = EBT × (1 - Tax Rate) = $70M × (1 - 0.25) = $52.5M. 2. Calculate Equity: Equity = Assets - Debt = $400M - $150M = $250M. 3. Calculate Return on Equity (ROE): ROE = NI / Equity = $52.5M / 250M=21.0250M = 21.0%. 4. Calculate Retention Ratio (b): b = (NI - Dividends) / NI = (52.5M - $21M) / $52.5M = 0.60. 5. Calculate SGR: SGR = ROE × b = 21.0% × 0.60 = 12.6%.

Question 8

A company currently has a return on equity of 18% and a dividend payout ratio of 40%. The board of directors has approved a policy change to increase the dividend payout ratio to 70%. Assuming the company's ROE remains unchanged, what will be the company's new sustainable growth rate?

  1. 12.6%
  2. 10.8%
  3. 7.2%
  4. 5.4% (correct answer)
Explanation: The SGR is a function of ROE and the retention ratio. The change in dividend policy affects the retention ratio.
  1. Original retention ratio (b_old) = 1 - 0.40 = 0.60.
  2. Original SGR = 18% × 0.60 = 10.8%.
  3. New retention ratio (b_new) = 1 - 0.70 = 0.30.
  4. New SGR = ROE × b_new = 18% × 0.30 = 5.4%.

Question 9

A corporation reports net income of $50 million, total shareholders' equity of $400 million, and pays out $15 million in common dividends. Assuming the firm does not issue new equity, what is its sustainable growth rate (SGR)?

  1. 12.50%
  2. 8.75% (correct answer)
  3. 3.75%
  4. 7.00%
Explanation: The sustainable growth rate (SGR) is calculated as the Return on Equity (ROE) multiplied by the retention ratio (b). \n1. Calculate ROE: ROE = \frac{\text{Net Income}}{\text{Shareholders' Equity}} = \frac{\text{\50M}}{\text{$400M}} = 12.5%\n2.Calculatetheretentionratio(b):\n2. Calculate the retention ratio (b):b = 1 - \text{payout ratio} = 1 - \frac{\text{Dividends}}{\text{Net Income}} = 1 - \frac{\text{$15M}}{\text{$50M}} = 1 - 0.30 = 0.70\n3.CalculateSGR:\n3. Calculate SGR:SGR = ROE \times b = 12.5% \times 0.70 = 8.75%$

Question 10

A firm has a sales forecast of $2 billion, a net profit margin of 6%, total assets of $1.5 billion, and a debt-to-equity ratio of 0.50. If the firm maintains a dividend payout ratio of 40%, what is its sustainable growth rate?

  1. 7.20% (correct answer)
  2. 4.80%
  3. 12.00%
  4. 8.00%
Explanation: To find the SGR, we first need to calculate Return on Equity (ROE) and the retention ratio (b).
  1. Net Income (NI) = Sales × Net Profit Margin = $2B × 0.06 = $120M.
  2. Equity = Total Assets / (1 + Debt/Equity Ratio) = $1.5B / (1 + 0.50) = $1.5B / 1.5 = $1B.
  3. ROE = NI / Equity = $120M / $1,000M = 12.0%.
  4. Retention Ratio (b) = 1 - Payout Ratio = 1 - 0.40 = 0.60.
  5. SGR = ROE × b = 12.0% × 0.60 = 7.20%.

Question 11

During a period of continuously rising inventory costs, a company changes its inventory accounting method from LIFO to FIFO. Assuming the company's dividend payout ratio and financial leverage remain constant, what is the most likely impact on its calculated sustainable growth rate for the year of the change?

  1. It will increase because reported return on equity will be higher. (correct answer)
  2. It will decrease because higher income taxes will reduce cash flow for reinvestment.
  3. It will remain unchanged because the change only affects working capital accounts.
  4. It will decrease because the increase in reported assets will lower asset turnover.
Explanation: In a period of rising prices, switching from LIFO to FIFO results in a lower Cost of Goods Sold (COGS), which leads to higher reported gross profit and net income. While ending inventory (assets) and therefore equity also increase, the percentage increase in net income is typically larger than the percentage increase in equity. This leads to a higher calculated Return on Equity (ROE). Since SGR=ROE×bSGR = ROE \times b and b is assumed constant, an increase in ROE will directly lead to an increase in the calculated SGR.

Question 12

A financial analyst calculates a company's sustainable growth rate to be 12%. The company's return on equity is 20%. If the company's net income for the year is $10 million, how much is it retaining for future growth?

  1. $4.0 million
  2. $1.2 million
  3. $8.0 million
  4. $6.0 million (correct answer)
Explanation: The question asks for the dollar amount of retained earnings. This requires first finding the retention ratio. \n1. Use the SGR formula to find the retention ratio (b): SGR=ROE×b  ⟹  b=SGRROE=12%20%=0.60SGR = ROE \times b \implies b = \frac{SGR}{ROE} = \frac{12\%}{20\%} = 0.60.
  1. The amount retained for growth is the net income multiplied by the retention ratio.
  2. Retained Earnings = Net Income × b = $10 million × 0.60 = $6.0 million.

Question 13

A company with a return on equity of 25% and a dividend payout ratio of 80% is seeking to increase its sustainable growth rate. Which of the following single changes would have the greatest positive impact on its SGR?

  1. Increasing the return on equity from 25% to 30%.
  2. Decreasing the dividend payout ratio from 80% to 70%.
  3. Decreasing the dividend payout ratio from 80% to 60%. (correct answer)
  4. Increasing the return on equity from 25% to 28%.
Explanation: First, calculate the current SGR. Then, calculate the new SGR under each scenario to find the largest increase. \n* Current State: Retention ratio b=1−0.80=0.20b = 1 - 0.80 = 0.20. SGR=ROE×b=25%×0.20=5.0%SGR = ROE \times b = 25\% \times 0.20 = 5.0\%. \n* Choice A: New SGR = 30% × 0.20 = 6.0%. (Increase of 1.0%) \n* Choice B: New b=1−0.70=0.30b = 1 - 0.70 = 0.30. New SGR = 25% × 0.30 = 7.5%. (Increase of 2.5%) \n* Choice C: New b=1−0.60=0.40b = 1 - 0.60 = 0.40. New SGR = 25% × 0.40 = 10.0%. (Increase of 5.0%) \n* Choice D: New SGR = 28% × 0.20 = 5.6%. (Increase of 0.6%) \nDecreasing the dividend payout ratio from 80% to 60% results in the largest increase in the SGR.

Question 14

A company's board is reviewing its financial policies. An analyst notes that the company's sustainable growth rate is negative. Assuming the company has positive shareholders' equity, a negative SGR most directly implies that the company:

  1. is paying dividends that are greater than its net income.
  2. has a debt-to-equity ratio greater than 1.0.
  3. is experiencing a net loss for the period. (correct answer)
  4. has a dividend payout ratio of more than 100%.
Explanation: The formula for SGR is SGR=ROE×bSGR = ROE \times b, where bb is the retention ratio (1 - payout ratio). The retention ratio bb is typically assumed to be between 0 and 1. If bb is in this range, the only way for SGR to be negative is if ROE is negative. Since ROE=Net IncomeEquityROE = \frac{\text{Net Income}}{\text{Equity}}, and we are told equity is positive, ROE can only be negative if Net Income is negative (i.e., the company has a net loss). While a payout ratio > 100% (Choice D) also mathematically leads to a negative SGR if ROE is positive, a net loss is the more fundamental and common cause of a negative ROE and thus a negative SGR.

Question 15

A company projects its return on equity will be 16%. It has total common equity of $200 million and targets a sustainable growth rate of 10%. To meet this target, what is the total dollar amount of dividends the company should plan to pay?

  1. $20.0 million
  2. $12.0 million (correct answer)
  3. $75.0 million
  4. $32.0 million
Explanation: This problem requires working backwards from the SGR target to find the implied dividend payment. \n1. Calculate the target retention ratio (b): b=SGRROE=10%16%=0.625b = \frac{SGR}{ROE} = \frac{10\%}{16\%} = 0.625. \n2. Calculate the target dividend payout ratio: Payout Ratio = 1−b=1−0.625=0.3751 - b = 1 - 0.625 = 0.375. \n3. Calculate the projected Net Income (NI): NI = ROE \times \text{Equity} = 16\% \times \200M = $32M.\n4.Calculatethetotaldollardividendstobepaid:Dividends=. \n4. Calculate the total dollar dividends to be paid: Dividends = NI \times \text{Payout Ratio} = $32M \times 0.375 = $12M$.

Question 16

Two companies, Firm A and Firm B, have the same return on assets (ROA) of 10% and the same dividend payout ratio of 30%. Firm A has a debt-to-assets ratio of 0.2, while Firm B has a debt-to-assets ratio of 0.5. Which of the following statements is most accurate regarding their sustainable growth rates (SGR)?

  1. Both firms have the same SGR because their ROA and payout ratios are equal.
  2. Firm A has a higher SGR than Firm B.
  3. Firm B has a higher SGR than Firm A. (correct answer)
  4. It is impossible to determine without knowing the firms' net profit margins.
Explanation: SGR depends on ROE, not ROA. We must convert ROA to ROE using the equity multiplier (EM = Assets/Equity). EM can be found from the debt-to-assets ratio (D/A) as EM=1/(1−D/A)EM = 1 / (1 - D/A). \n1. Both firms have a retention ratio b=1−0.30=0.70b = 1 - 0.30 = 0.70. \n2. For Firm A: EMA=1/(1−0.2)=1.25EM_A = 1 / (1 - 0.2) = 1.25. ROEA=ROA×EMA=10%×1.25=12.5%ROE_A = ROA \times EM_A = 10\% \times 1.25 = 12.5\%. SGRA=12.5%×0.70=8.75%SGR_A = 12.5\% \times 0.70 = 8.75\%. \n3. For Firm B: EMB=1/(1−0.5)=2.0EM_B = 1 / (1 - 0.5) = 2.0. ROEB=ROA×EMB=10%×2.0=20%ROE_B = ROA \times EM_B = 10\% \times 2.0 = 20\%. SGRB=20%×0.70=14.0%SGR_B = 20\% \times 0.70 = 14.0\%. \nSince Firm B has higher leverage, it has a higher ROE and therefore a higher SGR.

Question 17

A company's current sustainable growth rate is 10%, supported by a 25% return on equity. The company plans to improve its operating efficiency, which is expected to increase its ROE to 30%, with no change to its dividend policy. What will be the new sustainable growth rate?

  1. 12.0% (correct answer)
  2. 15.0%
  3. 8.3%
  4. 12.5%
Explanation: This is a multi-step problem. First, determine the current dividend policy (retention ratio), then apply it to the new ROE. \n1. Find the current retention ratio (b) using the SGR formula: SGR=ROE×b  ⟹  b=SGRROE=10%25%=0.40SGR = ROE \times b \implies b = \frac{SGR}{ROE} = \frac{10\%}{25\%} = 0.40.
  1. Since the dividend policy is unchanged, the retention ratio remains 0.40.
  2. Calculate the new SGR with the new ROE: New SGR = New ROE × b = 30% × 0.40 = 12.0%.

Question 18

A firm calculates its sustainable growth rate to be 9%. The board of directors has set a corporate growth target of 12% for the upcoming year, without any plans to alter its current profitability or dividend policy. To achieve this target while maintaining its dividend and profitability profile, the company will most likely need to:

  1. increase its dividend payout ratio to signal financial strength.
  2. rely solely on retained earnings and a proportional increase in debt.
  3. issue new equity or increase its debt-to-equity ratio beyond the current level. (correct answer)
  4. decrease its asset turnover ratio by investing in less productive assets.
Explanation: The sustainable growth rate (SGR) is the maximum growth rate a firm can achieve without external equity financing, while maintaining a constant debt-to-equity ratio. If the firm wants to grow faster than its SGR (12% > 9%) and its profitability (ROE) and dividend policy (retention ratio) are fixed, it must obtain additional capital. This can be achieved by either issuing new shares (external equity) or by increasing its debt-to-equity ratio (taking on proportionally more debt than assumed by the SGR).

Question 19

A company has a target sustainable growth rate of 8.4% and a firm policy of maintaining a 30% dividend payout ratio. To achieve its target growth rate, what return on equity (ROE) must the company generate?

  1. 28.0%
  2. 12.0% (correct answer)
  3. 5.9%
  4. 18.5%
Explanation: This question requires rearranging the SGR formula to solve for ROE. \n1. First, determine the retention ratio (b): b=1−payout ratio=1−0.30=0.70b = 1 - \text{payout ratio} = 1 - 0.30 = 0.70. \n2. The SGR formula is SGR=ROE×bSGR = ROE \times b. \n3. Rearrange to solve for ROE: ROE=SGRb=8.4%0.70=12.0%ROE = \frac{SGR}{b} = \frac{8.4\%}{0.70} = 12.0\%.

Question 20

A firm currently retains 70% of its earnings and has an ROE of 18%. If the firm's actual growth rate exceeds its sustainable growth rate, which of the following scenarios most likely explains this situation and its implications?

  1. The firm must immediately reduce its retention ratio to bring actual growth in line with sustainable growth rate calculations
  2. The firm has miscalculated its ROE, and the actual ROE must be higher than 18% to support the current growth rate
  3. The firm is operating efficiently within its sustainable growth framework, as the current retention ratio supports any growth rate
  4. The firm is operating above its sustainable growth rate temporarily by increasing financial leverage, but this cannot continue indefinitely without affecting capital structure (correct answer)
Explanation: When you encounter questions about growth rates exceeding sustainable levels, you're dealing with the fundamental relationship between a firm's growth capacity and its financing constraints. The sustainable growth rate represents the maximum growth a company can achieve without issuing new equity, calculated as: SGR=ROE×Retention RatioSGR = ROE \times \text{Retention Ratio} In this case, the firm's sustainable growth rate is 18%×0.70=12.6%18\% \times 0.70 = 12.6\%. When actual growth exceeds this rate, the firm must find additional financing sources beyond retained earnings. Answer D correctly identifies that the firm is likely increasing financial leverage (taking on more debt) to fund growth beyond what retained earnings can support. This strategy works temporarily but creates rising debt-to-equity ratios that eventually become unsustainable, as excessive leverage increases financial risk and borrowing costs. Answer A incorrectly assumes the firm must immediately adjust its retention ratio. While reducing retention could help, firms often prefer maintaining dividend policies and seeking alternative financing first. Answer B misunderstands the problem. The ROE calculation isn't necessarily wrong—the issue is that even with an 18% ROE, the current retention rate cannot sustain the higher growth rate through internal financing alone. Answer C completely misses the constraint. The retention ratio doesn't support "any" growth rate—it specifically limits sustainable growth based on available retained earnings. Study tip: Remember that sustainable growth rate represents a financing constraint, not an operational limit. When actual growth exceeds SGR, look for external financing sources, particularly increased leverage, as the temporary solution.