All else constant, which one of the following will increase the internal rate of growth?
|A. Decrease in the retention ratio.|
B. Decrease in net income.
C. Increase in the dividend payout ratio.
D. Decrease in total assets.
E. Increase in cost of goods sold.
The Correct Answer Is:
D. Decrease in total assets.
Correct Answer Explanation: D. Decrease in total assets.
Decrease in total assets will increase the internal rate of growth (IRR) of a company, all else being constant. This is because the internal rate of growth is a measure of a company’s ability to generate earnings from its existing resources.
By decreasing total assets, a company can potentially achieve higher returns on its remaining assets, leading to an increase in the internal rate of growth.
When a company reduces its total assets, it can focus on the most profitable and efficient uses of its resources. This might involve selling off underperforming or non-core assets, which can free up capital for more productive investments.
By doing so, the company can allocate its resources more effectively, potentially leading to higher returns on investment.
Now, let’s discuss why the other options are not correct:
A. Decrease in the retention ratio:
The retention ratio is the portion of earnings that a company chooses to retain and reinvest in the business rather than distribute as dividends to shareholders. A decrease in the retention ratio implies that a larger proportion of earnings is being paid out as dividends.
While this may be appreciated by shareholders in the short term, it can have negative implications for the company’s internal rate of growth. When a company retains a higher portion of its earnings, it can use that capital to reinvest in the business, such as funding research and development, expanding operations, or acquiring new assets.
These investments can lead to higher future earnings and a higher internal rate of growth.
Conversely, a decrease in the retention ratio means less money is being reinvested in the company. This could lead to missed growth opportunities, reduced ability to innovate, and a potential decline in long-term profitability, ultimately dampening the internal rate of growth.
B. Decrease in net income:
Net income is the profit that remains after all expenses, including taxes and interest, have been deducted from a company’s revenue. A decrease in net income indicates that a company is generating less profit.
When net income decreases, there is less money available to reinvest in the business. This can result in limited resources for funding new projects, expanding operations, or acquiring assets that could drive future growth. As a result, a decrease in net income is likely to lead to a decrease in the internal rate of growth.
C. Increase in the dividend payout ratio:
The dividend payout ratio is the proportion of earnings that a company pays out to shareholders in the form of dividends. An increase in this ratio means that a larger share of earnings is being distributed to shareholders.
While higher dividends may be appreciated by shareholders, it can limit the company’s ability to reinvest in growth opportunities. When a company retains a smaller portion of its earnings, there is less available for capital expenditures, research and development, and other investments that can fuel future growth. This can ultimately hinder the internal rate of growth.
E. Increase in cost of goods sold:
The cost of goods sold (COGS) represents the direct costs associated with producing or providing a product or service. An increase in COGS means that it is becoming more expensive for the company to generate revenue.
Higher COGS can squeeze profit margins, reducing the amount of money available for reinvestment in the business. This can lead to constraints on growth initiatives, potentially limiting the company’s ability to expand and innovate. Therefore, an increase in COGS is likely to result in a decrease in the internal rate of growth.
In summary, each of these options—decreasing the retention ratio, decreasing net income, increasing the dividend payout ratio, and increasing the cost of goods sold—can have negative implications for a company’s internal rate of growth.
They all involve scenarios where the company has less capital available for reinvestment, which can hinder its ability to pursue growth opportunities and ultimately lead to a decrease in the internal rate of growth.