Question

When economic activity falls, earnings fall, after some time, dividends are cut (Re = D1/P0   + g). Consider how these changes might increase the required rate of return for firms.

Answer 1

it will be increasing the required rate of return for the firms because their overall cost of capital will be going up and there will be a higher expectation of the investor in order to compensate for the risk of investment into this company as we can see that required rate of return will be reflecting the investors desire to invest into the company for a rate of return and when the economic situations are not that a smooth and the dividend has been cut, it will mean that there will be a lower growth rate in the the overall dividend and it would be leading to a higher rate of return because after we have adjusted the rate of return of company with the lower growth, the discounting of the overall dividend will be with a higher rate because of the lower growth of dividend.

It should be taken into consideration that we always deduct the growth rate of dividend from required rate of return and if there would be a lower growth of dividend, it will mean that there will be a higher required rate of return which will be transforming into a higher required rate of return and discounting factor.