(Measuring growth) Given that a firm's return on equity is 16 percent and management plans to retain 42 percent of earnings for investment purposes, what will be the firm's growth rate? If the firm decides to increase its retention rate, what will happen to the value of its common stock? a. The firm's growth rate will be %. (Round to two decimal places.)
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
![**Measuring Growth**
Given that a firm's return on equity is 16 percent and management plans to retain 42 percent of earnings for investment purposes, what will be the firm's growth rate? If the firm decides to increase its retention rate, what will happen to the value of its common stock?
a. The firm's growth rate will be [ ]%. (Round to two decimal places.)
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**Explanation:**
To find the firm's growth rate, we use the formula for the sustainable growth rate, which is:
\[
\text{Growth Rate} = \text{Return on Equity (ROE)} \times \text{Retention Ratio}
\]
Given:
- Return on Equity (ROE) = 16%
- Retention Ratio = 42% (or 0.42 in decimal form)
Calculate the growth rate as follows:
\[
\text{Growth Rate} = 16\% \times 0.42 = 6.72\%
\]
If the firm decides to increase its retention rate, it means they are reinvesting more of their earnings back into the company. Consequently, this can lead to a higher growth rate as more capital is available for growth opportunities. An increase in the growth rate can potentially increase the value of the firm's common stock, assuming the market perceives the reinvestment as favorable and capable of generating higher returns.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Fbfcd82b7-9f4b-4e80-bea9-f22c77c01173%2F658b14c7-f2d1-4b3a-a0c2-a5b545b3fa3e%2F58nljkl_processed.png&w=3840&q=75)
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