Question: (a) Assume the framework as outlined above in problem 5 with solution. Show that if the return that shareholders demand equals the firm's reinvestment rate (r, = r), the firm's share price should remain unaffected by the retention ratio b that the firm chooses. How do you explain your result?
(b) Assume that the firm has decided on a retention ratio b. In a particular year, the firm finds investments whose returns exceed the market capitalization rate on its equity . Should the firm alter its retention ratio in that year? What would you expect to happen to the firm's share price?
(c) What general conclusions would you draw from the above regarding the policy on retentions and dividends that a firm should follow?