Question

Robert Gillman, an equity research analyst at Gillman Advisors, believes in efficient markets. He has been following the mining industry for the past 10 years and needs to determine the constant growth rate that he should use while valuing Pan Asia Mining Company.

Robert has the following information available:

•	Pan Asia Mining Company’s stock (Ticker: PAMC) is trading at $16.25.
•	The company has forecasted net income and book value of equity for the coming year to be $1,025,700 and $8,027,500, respectively.
•	The company has also been paying dividends for the past 8 years and has maintained a dividend payout ratio of 32.50%.

Based on this information, Robert’s forecast of PAMC’s growth rate in earnings and dividends should be:

8.62%

-25.24%

6.23%

0.33%

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant?

Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business.

Paying a higher percentage of earnings as dividends will result in a higher growth rate.

Dividend growth and earnings growth are unrelated.

Answer 1

growth rate is computed as shown below:

= retention ratio x return on equity

= (1 - dividend payout ratio) x Net income / Equity

= (1 - 0.3250) x $1,025,700 / $8,027,500

= 8.62% Approximately

Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business accurately describes the relationship between earnings and dividends when all other factors are held constant.

growth rate is computed as follows:

= retention ratio x return on equity

As can be seen, paying a higher percentage of earnings as dividends will result in a lower growth rate since retention ratio will become lower. Hence the statement Paying a higher percentage of earnings as dividends will result in a higher growth rate is false

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