CFA Level I · CFA Level I Exam · Discounted Cash Flow (DCF) and Growth Models
A company reports a return on equity of 15% and pays out 40% of its earnings as dividends. Assuming the ROE and payout ratio are constant and no new equity is issued, the sustainable growth rate is closest to:
The sustainable growth rate is about 9.0%. It equals the earnings retention ratio of 60% multiplied by the 15% return on equity. Using the 40% payout ratio instead of retention would wrongly give 6.0%.
- A6.0%
- B9.0%Correct
- C15.0%
Explanation
Retention ratio = 1 - 0.40 = 0.60. Sustainable growth = retention x ROE = 0.60 x 15% = 9.0%. The 6.0% figure wrongly uses the payout ratio instead of the retention ratio.
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