QBank Equities Question something, currently, question, increase, decrease

hardwork24

Let me know what you guys make of this question its got me a little confused

A company currently has a required return on equity of 14% and an ROE of 12%. All else equal, if there is an increase in a firm’s dividend payout ratio, the stock's value will most likely:

A) increase.


B) either increase or decrease.


C) decrease.


The answer is A in Qbank, but I thought it would be C since the growth rate decreases, decreasing the denominator.

I'm sure I'm just not grasping something easy but an explanation would be greatly appreciated.

Thanks in advance

waldziuchna

I got that part wrong. definitely was not thinking right.

Since the numerator has a (1+g) on it, it will be a higher number than the denominator (r-g) which is < 1 - even though the g factor there has increased. So the Price would increase.


Sorry about the wrong response earlier.

CP

nitoha

CPK,

if the dividend pay out increases, then b should decrease. I'm not sure why u said b increases....

I think the reasoning is as follows (assuming all else is constant):

If payout increases, the company retains less for re-investment, so retention ratio (b) decreases

since b decreases, growth (g) decreases as (remember the formula g=b*ROE)

As a result (r-g) increase....but also keep in mind that Div payout also increased as stated by the question.

Since the numerator (div payout) and the denominator (r-g) increases, the price will increase as well. Pure arithmetic here.

So the answer is A.

draz

the question doesn't say anything about growth rate decreasing.