Question

Using the dividend growth model, explain why a firm would be hesitant to reduce the growth rate of its dividends.

Answer 1

Value of stock = D1 / (k - g)

where:
D1 = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return, which can be estimated using the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model (see Cost of Equity)
g = the expected dividend growth rate (note that this is assumed to be constant)

In the above formula, it can be observed that If the growth rate will reduce, the denominator will increase and thereby decreasing the price of the stock. Similarly, if the growth rate will increase, it will reduce the denominator and thereby increasing the price of the stock. Thus, it can be concluded that growth rate have a direct relationship with the price of the stock. That is, if growth rate increases, the price increases and if the growth rate decreases, the price also falls.

Hence, it can be concluded that the company will be hesitant to reduce the growth rate of dividend because it will affect the price of stock and decrease the price of the stock.