Question

Low Tech Company has an expected ROE of 10%. The dividend growth rate will be ________ if the firm follows a policy of paying 40% of earnings in the form of dividends.

A. 3%
B. 4%
C. 4.8%
D. 6%

Answer 1

The dividend growth rate for Low Tech Company will be 6%, calculated using the sustainable growth rate formula with an ROE of 10% and a retention rate of 60%.

Step-by-step explanation:

The low Tech Company's dividend growth rate can be determined using the formula for sustainable growth rate (SGR), which is defined as the product of the return on equity (ROE) and the retention rate (the proportion of earnings that is not paid out as dividends). Given that the expected ROE is 10% and the firm plans to pay 40% of its earnings as dividends, the retention rate is the remaining 60% (100% - 40%). Using the SGR formula, we calculate the dividend growth rate as:

SGR = ROE × Retention Rate
SGR = 10% × (1 - 0.40)
SGR = 10% × 0.60
SGR = 6%

Therefore, the firm's dividend growth rate would be 6% if it pays out 40% of its earnings in dividends.