Question

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? a. Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business. b. Dividend growth and earnings growth are unrelated. c. Paying a higher percentage of earnings as dividends will result in a higher growth rate.

Answer 1

Answer:

a.) Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business.

Explanation:

Retained earnings are portions of a firm's net income that is plowed back into the business. For example if it makes a net income of $2,000,000 and it pays out 30% of that as dividends, the dividends in dollars would be 0.30*2,000,000 = $600,000. The remaining portion i.e 70% is retained back into the company, hence the amount would be 0.70*2,000,000 = $1,400,000.

This retained amount could be used to invest in potential profitable businesses that will result in increase in shareholder value. In a nutshell,  the higher percentage of  retained earnings the higher the growth rate a company will experience.