Which of the following is true about the sustainable growth rate (SGR) in the context of investments in securities?

• A. The sustainable growth rate represents the maximum rate at which a company can grow its sales, earnings, and dividends without having to increase financial leverage or issue new equity.
• B. The sustainable growth rate is calculated as the company's net income divided by its total assets.
• C. The sustainable growth rate measures the rate of return required by investors to invest in a company's securities.
• D. The sustainable growth rate is only relevant for companies that do not pay dividends.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of Sustainable Growth Rate (SGR). The SGR represents the maximum rate at which a company can grow its sales, earnings, and dividends without increasing financial leverage or issuing new equity. It is a measure of growth that can be sustained using internally generated resources.
2. Step 2: Clarify the formula for calculating the Sustainable Growth Rate. The SGR is typically calculated using the formula: SGR = ROE × (1 - Dividend Payout Ratio), where ROE is the Return on Equity and the Dividend Payout Ratio represents the proportion of earnings paid out as dividends.
3. Step 3: Evaluate the first statement: 'The sustainable growth rate represents the maximum rate at which a company can grow its sales, earnings, and dividends without having to increase financial leverage or issue new equity.' This aligns with the definition of SGR and is correct.
4. Step 4: Assess the second statement: 'The sustainable growth rate is calculated as the company's net income divided by its total assets.' This is incorrect because the formula for SGR involves ROE and the Dividend Payout Ratio, not net income divided by total assets.
5. Step 5: Review the remaining statements: 'The sustainable growth rate measures the rate of return required by investors to invest in a company's securities' and 'The sustainable growth rate is only relevant for companies that do not pay dividends.' Both are incorrect because SGR does not measure investor-required returns, and it is relevant for companies regardless of whether they pay dividends, as it considers retained earnings.