Hi
Kindly help me with this scenario. If a company has an ROE=7% and Ke (Cost of Equity)= 10%. Should the company pay dividends?
Please answer in Yes/No along with the logic.
Yes. If the company retains its earnings, it is only going to earn 7% if current ROE is representative of future profitability (which we usually assume it to be, albeit with some noise). On the other hand, similarly risky activities across the market are paying 10% on average. Thus, a shareholder would be better off taking the profits and investing them in those other companies earning 10%, rather than having the company keep the profits and reinvest them in its own operations for 7%.
Another way to look at it is that raising equity capital in order to grow is going to cost 10% in order to entice an investor, but it is only expected to return 7% based on the ROE, so to grow the company is going to result in a 3% loss on any invested capital. The company basically needs to shrink, go out of business or figure out how to be a less risky business where 7% is considered a reasonable return in compensation for its risk.
More importantly, how does a passed level 3 not know this?