CFA Practice Question

There are 151 practice questions for this study session.

CFA Practice Question

In theory, a firm wanting to maximize share value should pay out as much of its earnings in dividends as possible if it believes that:

A. investors are indifferent to the form of their return.
B. the company's future growth rate will be below its historical average.
C. the company will still have positive cash flow.
D. the company's future return on equity will be below its required rate of return.
Correct Answer: D

User Contributed Comments 8

User Comment
setmefree larger div payout is aimed to compensate for low ROE, hence lower capital gain? the firm is striking to balance, thus to max shareholder's return?? I dun get this question at all!!
setmefree okay, lets try reverse engineering: P = D/(k-g)if expected ROE is low, g will be low, this effects share price negatively; to offset, div payout has to be large, which also increases g, this makes sure P increases. But how can you rule out answer B?!???
stefdunk because the growth rate may still be above market rate
katybo if ROE < rr, you better return the capital to the shareholders via dividens so then can invest the money in a more profitable company.
haarlemmer Let's try in this way. By paying out more dividend, the company has lower retained earnings, thus lower equity. It may be used to offset the lower expected ROE as equity part could be reduced.
Nightsurfer Retaining the dividend puts it to an inefficient use. Investors can find a better use outside the firm.
cp24 r = D/P +g ; g = ROE x retention rate

For D, a lower ROE results in a lower g (assuming the retention rate does not change) so to compensate increase D;
B is not correct. historical average has nothing to do with required rate of return.
davidt87 cp24 you cant keep the retention rate unchanged if you increase the dividend payout. they are reciprocal.

also i don't think the dividend discount model is the best way estimate the required rate of return and this question is meant to be conceptual.

but in that equation increasing D does drive down r, so long P/B > 1..

Which makes sense because investors would be skittish if you were increasing your payout ratio when P/B is less than 1.
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