Investment Analysis: Firm A vs. Firm B

Comparison of Growth Rates, Debt-to-Equity Ratios, and Profit Margins

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Question

Two firms, A and B, have identical operations set up (except for their relative sizes). A has a debt-to-equity ratio of 0.4 while B has it at 0.3. A's profit margin is 1.2 times that of B but its sales force is not as effective as that of B. Hence, A's asset turnover is 0.9, compared to B's ratio of 1.15. A pays out 45% of its earnings as dividends while B pays out only 20%. Given this, the ratio of A's growth rate to B's growth rate must be:

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A. B. C. D.

Explanation

Use g = ROE * retention ratio and

ROE = profit margin * asset turnover * financial leverage.

Financial leverage = assets/equity = 1 + debt/equity.

The ratio of A's growth rate to B's growth rate equals 1.2*(0.9/1.15)*[(1+0.4)/(1+0.3)]*[(1-0.45)/(1-0.20)] = 0.70

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