Internal and Sustainable Growth Rates in the Presence of Scale Economies

Abstract

Corporate finance theory provides both precise and approximate formulas for the maximum growth rate of a firm, typically called the internal growth rate (when no external funds are permitted) and the sustainable growth rate (when the capital structure is held fixed). The assumption in these approaches is that the firm experiences constant returns to scale in that sales and assets grow in parallel. Yet empirical studies repeatedly find that the production functions facing firm display modest increasing returns to scale in that seldom must assets double to double sales. Firms can grow faster when bound to using only internal sources of funding and when firms maintain a constant debt-equity ratio in the presence of scale economies. Using homogeneous production functions, the revised formulas increase the maximum rate of growth that a firm could achieve and have the traditional formulas as a special case of the more general formulas for internal and sustainable growth.