Question

Stock A has a required return of 10.00%, while Stock B has a required return of 8.00%. Which of the following statements is CORRECT?

a.   If Stock A and Stock B have the same current dividend and the same expected dividend growth rate, then Stock A must sell for a higher price.
b.   Stock A must have a higher dividend yield than Stock B.
c.   The stocks must sell for the same price.
d.   If the market is in equilibrium, and if Stock A has the lower expected dividend yield, then it must have the higher expected growth rate.
e.   If Stock A and Stock B have the same dividend yield, then Stock A must have a lower expected capital gains yield than Stock B.

Answer 1

Price of stock after 1 year = (Dividend received now)/(Return rate - Growth rate)

So we can see the price of the stock is inversely proportional to the return rate. So statement A is false. Stock 2 shall sell for a higher price.

Dividend yield = dividend/ share price. As dividends on both are considered the same, and stock 1 has a lower price, so:

Stock A must have a higher dividend yield than stock B but for it, both stocks must be paying same dividend, so it is not always true, the presence of must in statement B makes it false.

We can not comment on the prices of the stocks until we know the dividend paid, and the growth rate, so statement C is also false.

growth rate = Return rate - (Dividend received/Price of stock)

= Return rate - Dividend yield

So the statement D is true, as stock A is having higher returns and lower dividend yield, hence according to the above equation, it will have a higher growth rate.

Capital gains yield = (Price after one year - Price now)/Price now

We cannot say about the E-statement until we know what the dividends are being paid, so the statement E is also false.

Answer: D

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