Explanation

The sustainable growth rate (SGR) formula is:

SGR = ROE × (1 - Dividend Payout Ratio)

Where ROE = ROA × Financial Leverage

Given that ROA is the same for both scenarios, we can analyze:

Scenario 1:

• Dividend payout ratio = 60% (retention ratio = 40%)
• Financial leverage = 3.0
• ROE₁ = ROA × 3.0
• SGR₁ = (ROA × 3.0) × (1 - 0.60) = (ROA × 3.0) × 0.40 = ROA × 1.2

Scenario 2:

• Dividend payout ratio = 40% (retention ratio = 60%)
• Financial leverage = 2.5
• ROE₂ = ROA × 2.5
• SGR₂ = (ROA × 2.5) × (1 - 0.40) = (ROA × 2.5) × 0.60 = ROA × 1.5

Comparison:

• SGR₁ = ROA × 1.2
• SGR₂ = ROA × 1.5

Since ROA is the same positive value for both scenarios, SGR₂ > SGR₁.

Key Insights:

1. Lower dividend payout ratio (40% vs 60%) means higher retention of earnings for reinvestment
2. Although financial leverage is lower in Scenario 2 (2.5 vs 3.0), the higher retention ratio more than compensates
3. The combined effect of retention ratio and leverage determines SGR

Therefore, the sustainable growth rate is higher under Scenario 2.