Question

Assume that Firm XYZ’s ROE= 15%, its beta = 2, the market return = 15%, the risk-free rate = 5%. The firm’s current Dividend Payout Ratio = 60%. If the firm increases its Dividend Payout Ratio to 80%, its instinct value will

a)Increase

b)Decrease

c)Stay the same

d)Not enough information to decide

e)First decrease in short-term and then increase in the long-term

Answer 1

Return on Equity = 15%

As per CAPM, Expected return on stock (cost of equity) = Risk free rate + Beta x Market risk premium

Expected return on stock (cost of equity) = Risk free rate + Beta x (Market returns - risk free rate)

Expected return on stock (cost of equity) = 5% + 2 x (15%-5%) = 25% p.a.

Since cost of equity > Return on equity, increase in dividend payout ratio will lead to increase in value of share. Since company is able to invest its funds at 15%. However, required returns from stock is 25%. So any increase in dividend payment would lead to increase if value of share.

Option a) is correct. Increase

If cost of equity < Return on equity, increase in dividend payout ratio will lead to decrease in price. Since company can invest the funds at higher than cost of equity (required returns on equity), increase in dividend payout would lead to decrease in price as company would now be able to reinvest less funds at higher rate.

if cost of equity = Return on equity, any change in dividend payout won't impact stock price