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Do Homework Ira Randall- Google Secure I https:/www.mathxl.com/Student/PlayerHomework.aspx?homeworkld-4 MBA 579 (Summer 2018) Homework: Chapter 10 Homework Score: 0 of 2 pts 3 of 6 (0 complete) P10-6 (similar to) Save HW Score: 0%, 0 Question Help * (Measuring growth) Given that a firm\'s return on equity is 21 percent and management plans to retain 45 percent of earnings for investment purposes, what will be the firm\'s growth rate? If the firm decides to increase its retention rate, what will happen to the value of its common stock? a. The firm\'s growth rate will be ?%. (Round to two decimal places )

Solution

a) Return on equity (r) = 21%

Retention ratio (b) = 45% or 0.45

Growth rate = b x r = 21% x 0.45 = 9.45%

b) Stock price is computed as -

P0 = D1 / (Ke - g)

where, P0 = stock price today, D1 = expected dividend, Ke = required return, g = growth rate

If retention ratio increases, the growth rate, in turn, will increase. Increase in growth rate would increase the denominator in the above formula thereby increasing the stock price.