Question

Which of the following items is not a characteristic of a common stock?

a. It offers the chance for the firm to remain in business forever

b. It gives the owner priority if the firm files for bankruptcy

c. It represents a claim against future common dividends

d. Its market value is constantly changing

e. It represents ownership in the firm

Under which of the following circumstances can you not use the DDM to value a stock?

a. When the dividend is not expected to grow

b. When the dividend growth rate is higher than the required return to the stock

c. During an economic contraction

d. When interest rates are higher than stock returns

e. When the dividend is expected to grow at a non-constant rate

Based on the DDM, if the required return on a stock increases, what will happen to the stock’s price?

a. It will increase

b. It will remain the same

c. It will either increase or decrease

d. There is not sufficient information to answer this question

e. It will decrease

Based on the DDM, if the dividend growth rate increases, what will happen to the stock’s price?

a. It will decrease

b. There is not sufficient information to answer this question

c. It will increase

d. It will either increase or decrease

e. It will remain the same

Answer 1

1. Common stocks refers to the stocks issued to the common shareholders who enjoy the lifetime ownership in the company till liquidation or selling of common stocks to third parties. It's feature includes to remain forever as company's enjoy perpetual succession, claim against future common stocks and it's market price changes constantly.

Here the common stocks refers to the ownership, so they are last priority when a bankruptcy is filed and company is liquidated.

Thus the correct Option is-------------B i.e It gives the owner priority if the firm files for bankruptcy.

2.

DDM refers to the dividend discount model which is a simple way to calculate the stocks it's assumption involved the expected rate of return, future dividend and the dividend growth rate.

The formula used to get the price of stock = Expected dividend / (Expected return- growth rate).

Here if the expected growth rate is higher the denominatior will become negative which will lead it impossible to get the price as negative price is not possible.

Thus the correct Option is-------------B i.e When the dividend growth rate is higher than the required return to the stock.

3.

If the required return on stock increases and the growth rate remains constant based on the formula the denominator will start increasing as the difference in expected rate of return and growth rate will rise, this increased denominator will lead to decrease in the price of the stocks.

Thus the correct Option is-------------E i.e It will decrease.

4.

In the same way as discussed in 3rd part, if the growth rate increase the denominator will reduce which will lead to the increase in the stock prices assuming expected rate is constant.

Thus the correct Option is-------------C I.e It will increase.