Question

Under which of the following scenarios will increasing the payout ratio for a firm increase its...

Under which of the following scenarios will increasing the payout ratio for a firm increase its equity value?

•A) Never

•B) Always

•C) When the return on equity is equal to its cost of equity

•D) When the return on equity is less than the cost of equity

•E) When the return on equity is greater than the cost of equity

WHY? Could I please have the explanation. Thank you

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Answer #1

The answer is

•D) When the return on equity is less than the cost of equity

The company generates return on equity retained. Retention of income is desirable when the income generated on retained funds is higher than the cost of capital (as it represents income which can be earned by the shareholders on dividend payments).

Therefore, if the company can generate higher return on equity than the cost, then only it should retain funds

Otherwise paying dividend will increase the value of the firm.

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