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

draz

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

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.

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