What effect on the growth rate of earnings can be accomplished by decreasing the dividend payout ratio from 70% to 40% if the firm has an ROE of 20%?
A) The growth rate can increase from 6% to 10.5%.
B) The growth rate can increase from 6% to 12%.
C) The growth rate can increase from 8% to 14%.
D) The growth rate can increase from 11% to 14%.

Question

Quizplus · Accepted Answer

The formula for the sustainable growth rate (SGR) is SGR = ROE x (1 - dividend payout ratio).
With an ROE of 20%, decreasing the dividend payout ratio from 70% to 40% would increase the SGR from 6% [(0.20 x (1 - 0.70))] to 12% [(0.20 x (1 - 0.40))]. Therefore, the growth rate can increase from 6% to 12%. Option B is the only choice that matches this calculation.

What Effect on the Growth Rate of Earnings Can Be