Question

A CFO says, “The dividend growth model implies that the current stock price equals the present value of future dividends. We thus increase dividend payouts rather than retaining earnings to maximize the stock price.” Do you agree with the CFO? Justify your answer. (You do not have to criticize the dividend growth model but discuss the CFO’s interpretation of the model.)

Regarding the CFO’s statement above, a treasurer responds as follows: “I do not agree. Retained earnings can be reinvested in our projects, which provide growth opportunities to our firm. We thus rather retain earnings as much as possible in any circumstances.” Do you agree with the treasurer? Justify your answer. (Your objection to CFO’s statement above does not necessarily imply that you agree with the treasurer. Assess the treasurer’s statement independently.)

Answer 1

This statement of chief financial officer is partially correct because divident discount theory is not always practically correct as the firm stock price is not the correct reflection of the future value of its dividend, so it will only be a reflective of a lower portion of the total share value, because share value are always driven by high earnings and high profit growth.if the chief financial officer had to be correct then all those dividend paying stocks would have been valued the highest

The statement of treasurer is also not correct because retained earning is to be kept with the company in those cases when the reinvestment rate of the company is lower . So a company should only be retaining the earning and investing into the project if it does not have a higher rate of return over cost of debt . So I do not agree with the treasury statement as well.