ABC Company has consistently paid out 40% of its earnings in dividends. The company's return on equity is 16%. Calculate ABC's estimated dividend growth rate.
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A. B. C. D. E. F.Explanation
The estimated growth rate of dividends = (Retention Rate) x (Return on Equity). In this case, the estimated growth rate of dividends = 60% x 16% = 9.6%.
To calculate ABC Company's estimated dividend growth rate, we need to use the dividend payout ratio and the return on equity (ROE) figures provided.
The dividend payout ratio is the proportion of earnings that a company distributes as dividends. In this case, ABC Company has consistently paid out 40% of its earnings in dividends. This means that for every dollar of earnings, ABC Company distributes $0.40 as dividends.
The return on equity (ROE) is a measure of a company's profitability, indicating how much profit is generated for each dollar of shareholder equity. In this case, ABC Company has a return on equity of 16%. This means that for every dollar of shareholder equity, ABC Company generates a profit of $0.16.
The dividend growth rate can be estimated using the formula:
Dividend Growth Rate = Retention Ratio × Return on Equity
The retention ratio is the proportion of earnings that a company retains and reinvests back into the business. It can be calculated by subtracting the dividend payout ratio from 1.
In this case, the dividend payout ratio is 40%, so the retention ratio is:
Retention Ratio = 1 - Dividend Payout Ratio = 1 - 0.40 = 0.60
The return on equity is given as 16%.
Now we can calculate the dividend growth rate:
Dividend Growth Rate = Retention Ratio × Return on Equity = 0.60 × 0.16 = 0.096 or 9.6%
Therefore, ABC Company's estimated dividend growth rate is 9.6%.
The correct answer is F. 9.6%.