Question

3. Expected returns, dividends, and growth The constant growth valuation formula has dividends in the numerator. Dividends are divided by the difference between the required return and dividend growth rate as follows: ſo = Dale (rs - g) Which of the following statements is true? o Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth. O Increasing dividends will always increase the stock price. O Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources.

Answer 1

part a: option-1 is correct as the growth rate of dividend is calculated as,

sustainable growth rate = ROE X retention ratio = ROE X (1-dividend payput ratio),

and as the dividend paid increase, the growth rate decrease, therefor driving the price in opposite direction.

The net result of this would be the price may increase or decrease depending upon ROE and expected return.

part b: We know, P = D1/(r-g),

rearranging this, we have, r = D1/P + g = (2.25/20) +0.065 = 0.1775 or 17.75%

Ans. Expected rate of return = 17.75%

part c: The correct answer is option-1

The dividend yeild is calculated as, Div. yield = D1/P = r-g, and as long as these two parameters remains constant, the dividend yield would remain constant.