2581-Advanced Financial Management-2425_S2

This question asks what would happen to the share price if instead of a 100% payout ratio, it were to have a policy of distributing only 40% of its earnings as dividends and the remaining would be invested to generate an ROE of 8%.

Here, the following formula will enable us to calculate the share price: S0 = Dividend x (1+g)/(R-g)
Where dividend = €5 x 40% = 2
And growth rate = 60% x 8% = 4.8%

S0 = 2 x (1+4.8%) / (10%-4.8%) S0 = €40.3

In this way, students may prove mathematically that the price will go down. Alternatively, using intuition, students could understand that the price will decrease as the ROE (8%) < Return required by shareholders (10%), which means if the company is retaining part of its earnings, it will generate less than the discount rate, justifying a lower share price.