Optimality of Capital Structure Inherent in Sustainable Growth Rate (SGR)

Abstract

The present paper is a revised version of an article written by the lead author with a co-author and published in 2008 in which the derived formula and analyses were wrong. In the present paper a new approach to determine optimum D/E ratio has been proposed after making all necessary corrections of the first article. In literature the definition of SGR is: 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 rate, b. SGR formulations available in literature do not consider variable liability as an internal source of financing, and thus, these formulations underestimates SGR. The present study proposes a new formula to calculate optimal D/E ratio of a company at its various levels of SGR. The model considers variable/spontaneous liability as an important internal source of financing. The proposed model derives an implicit relationship between D/E ratio and SGR. From that implicit relationship, the optimal D/E ratio of a company can be calculated for a given level of SGR of the company. As in the first version of this article, we can trace out a SGR―D/E expansion path or continuum. From this continuum, the optimum D/E can be determined for a given level of SGR, and vice versa. The present study empirically finds that at a positive SGR, optimum D/E is zero. This level of SGR can be called the cut-off point. However, initially as D/E increases, SGR also increases at an increasing rate. But there is a limit to increase of D/E. At that level, SGR suddenly becomes negative. This level of and at one level of D/E ratio, SGR reaches its maximum. After that level of D/E ratio, SGR becomes negative. This value of D/E is the optimum or breakeven value of D/E ratio. If the company further increases it’s D/E, SGR will remain negative but its absolute value will fall. Empirical test supports the findings of this study.