CS Executive · Corporate Accounting and Financial Management · Dividend Decisions
According to Gordon's model, if r is greater than k, what is the effect of increasing the retention ratio on the market price of the share?
The price increases. When the firm's return on investment exceeds the cost of equity, retaining more earnings creates more value for shareholders than distributing them. Growth rises enough to outweigh the lower current dividend, so under Gordon's model a growth firm should retain all earnings.
- APrice increasesCorrect
- BPrice decreases
- CPrice remains unchanged
- DPrice becomes zero
Explanation
When r exceeds k, the firm earns more on retained funds than shareholders could earn elsewhere. A higher retention ratio raises growth br by more than it reduces the dividend's weight, so the price rises. The optimal payout is therefore zero for a growth firm.
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