EQUITY currently, company, required, increase, decrease

busprof

Given the explanation below, if the required return on equity was 14% (the same) but ROE = 20%, would the right answer be DECREASE?



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) either increase or decrease.


B) increase.


C) decrease.



Your answer: B was correct!


Increase in dividend payout/reduction in earnings retention.In this case, an increase in the dividend payout will likely increase the P/E ratio because a decrease in earnings retention will likely increase the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay out earnings rather than investing in lower-yield projects. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would rise, as investors will value the company higher if it retains a lower percentage of earnings.

Given the explanation above, if the required return on equity was 14% (the same) but ROE = 20%, would the right answer be DECREASE?

ftwcfa

That would seem logical as investors would prefer earnings be retained and invested in the higher yielding projects

Siddimaula

Philly1616 Wrote:
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> Given the explanation above, if the required
> return on equity was 14% (the same) but ROE = 20%,
> would the right answer be DECREASE?

Correct.