Sustainable Growth Rate and Optimal Capital Structure

Abstract

Sustainable growth rate (SGR) is the maximum sales growth rate, measured from a base sales level, which a company can support without any additional external equity financing while maintaining a target Debt-Equity (D/E) ratio, given the retention ratio, b. SGR formulations available in literature do not consider variable liability as an internal source of financing, and thus, these formulations underestimate SGR. The present study proposes a new formula to correctly calculate SGR which includes variable liability as an internal source of financing, to examine the impact of D/E ratio on SGR, to construct SGR–D/E Ratio Continuum, and, thereby, to determine optimal D/E ratio of a company based on its forecasted level of sales growth rate. That is, the study proposes that SGR formulation is an alternative tool to determine the optimum D/E ratio for a given level of forecasted sales growth rate of a company. The study finds that as D/E ratio increases, SGR also increases and at one level of D/E ratio, SGR reaches its maximum. After that level of D/E ratio, SGR becomes negative. This relationship between SGR and D/E ratio is true if a company is not already in financial distress. The present study finds that based on the forecasted level of sales growth rate of a company the optimum level of D/E ratio or optimum capital structure can be determined from the proposed SGR–D/E Ratio Continuum. This is a new approach to determine optimum D/E ratio in financial management. Empirical test supports the findings of this study.