[Ram CParticipant]

I’m curious about how to interpret the effects of a dividend policy change using both the Gordon Growth Model and general equity valuation principles. Could someone explain the reasoning behind the

I’m curious about how to interpret the effects of a dividend policy change using both the Gordon Growth Model and general equity valuation principles. Could someone explain the reasoning behind the correct answer and how the different factors like required return, growth rate, and dividend payout interact in this context?

 

This was a question from the Topic Test:

 

XYZ Corporation recently announced a significant increase in its dividend payout ratio, moving from 20% to 40%. This announcement led to a surge in the company’s stock price. However, analysts are debating the long-term implications of this change. Consider the following statement

 

1. An increase in the dividend payout ratio could indicate management’s confidence in the stability of future earnings.
2. Higher dividend payouts reduce the amount of retained earnings available for reinvestment in the business, potentially leading to slower growth.
3. According to the Gordon Growth Model (Dividend Discount Model), an increase in the dividend payout ratio should always lead to a higher stock price, assuming all else remains constant.
4. The impact on the stock price from the increased payout ratio depends on the trade-off between the required return on equity (r) and the growth rate of dividends (g).

Which of the following is most accurate?

A. Only Statement 1 is correct.
B. Statements 1 and 2 are correct, but Statement 3 is incorrect.
C. Statements 2 and 3 are correct, but Statement 1 is incorrect.
D. Statements 2, 3, and 4 are correct, but Statement 1 is incorrect.
E. Statements 1, 2, and 4 are correct, but Statement 3 is incorrect.

 

Apparently the answer is Choice E

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[Madhu Chandarasekaran, CFAKeymaster]

• Statement 1 is correct as it reflects investor perception regarding management’s confidence.
• Statement 2 is correct as it highlights the p

• Statement 1 is correct as it reflects investor perception regarding management’s confidence.
• Statement 2 is correct as it highlights the potential negative impact on growth due to lower retained earnings.
• Statement 3 is incorrect because the relationship between dividend payout and stock price is not straightforward and depends on other factors, particularly the growth rate.
• Statement 4 is correct as it correctly identifies the importance of the trade-off between the required return and the growth rate.

Thus, the correct answer is E.

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