Question

CFA Question

At Litchfield Chemical Corp. (LCC), a director of the company said that the use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price.
a) Using a constant-growth dividend discount model as a basis of reference, evaluate the director’s statement.
b) Explain how an increase in dividend payout would affect each of the following (holding all other factors constant):
i. Sustainable growth rate.
ii. Growth in book value.

Answer 1

a.) Statement by director: Use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price

Evaluation of statement: Constant growth DDM Formula => P0 = D0*(1+g) / (ke-g)

As we can see from the above equation, Price of the stock is directly proportional to Dividend, hence raising the dividend will result in an increase in stock price. Therefore, the statement is CORRECT.

b. (i) Effect of increase in dividend payout on sustainable growth (holding all other factors constant)

Dividend payout = (1-retention rate) or (1-b). Increasing the dividend payout will decrease the retention rate or b.

Since g= b* ROE, decrease in b will directly result in a decrease in g.

Hence, an increase in dividend payout will lead to decrease in sustainable growth

(ii) Effect of increase in dividend payout on growth in Book value (holding all other factors constant)

Increasing the dividend payout will decrease the retained earnings of the company and thus would negatively affect the growth in book value as less amount of retained earnings will be added to book value.