Question

Your company has steady earnings of $4/share, no retained earnings, and is currently selling for $40/share. A junior executive has suggested that you reduce the dividend by half and invest the retained earnings in new projects that will return the same ROE as the firm’s current assets, 16%. Assuming these additional new projects that will pay a return equal to the current ROE, is this a good idea? Prove your answer. Please show all work and do not use excel or a finance calculator.

Answer 1

Yes, this is a better idea because project is returning a return of almost 16% on return on equity.

The required rate of return of investor is 10%(4/40), and if the company generating a return on equity of 16% then it should be trying to re invest its Australia earnings back into the business in order to provide investors with returning a higher rate of return on equity is so this is a good idea and investor dividend should be cut out and there should be reinvestment made in the business which will be enhance the rate of return of investor to a large extent and it will help the company in order to maximize the rate of return by providing the investor with the 16% return on equity.

Investors also agree on this proposal as it will maximize their return to a large extent because the rate of return on equity is quite handsomely beating their required rate of return.