Question

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

Answer 1

If a firm decreases its sustainable growth rate (g), the price of their stock will probably decrease. I will use the following example:

P₀ = Div₁ / (Re - g)

• Div₁ = $2
• Re = 12%
• g = 5%

P₀ = $2 / (12% - 5%) = $28.57

if the growth rate g decreases to 2%, and the rest remains unchanged, then

P₀ = $2 / (12% - 2%) = $20