Chartered Financial Analyst (CFA) Practice Exam Level 2

In a multi-stage Dividend Discount Model (DDM), what determines the dividends in the growth phases?

1. Constant growth rate over the long term

2. Proportional change based on retained earnings

3. Historical dividend payout ratio

4. Market price adjustments

The correct answer is: Proportional change based on retained earnings

The dividends in the growth phases of a multi-stage Dividend Discount Model (DDM) are primarily determined by proportional change based on retained earnings. In this model, companies typically reinvest a portion of their earnings back into the business, which can lead to increased dividends over time as the company grows. The retained earnings contribute to the overall growth of the company, allowing it to fund future projects, expand operations, or increase its dividend payout. By utilizing retained earnings effectively, companies can generate higher future profits, which can then be distributed to shareholders as dividends. This approach considers the relationship between earnings and dividends, highlighting how reinvested profits can influence dividend growth during different phases of the company's lifecycle. While elements like the historical dividend payout ratio and constant growth rates may provide some context or context in specific scenarios, they do not directly dictate the growth of dividends in the same way that the adjustments based on retained earnings do. Market price adjustments, on the other hand, are more concerned with how investors perceive the stock's value rather than the underlying mechanics of dividend growth.