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The required returns of Stocks X and Y are rX = 10% and rY = 12%
The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT?
- a) If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.
- b) If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X.
- c) if Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price.
- d) The stocks must sell for the same price.
- e) Stock Y must have a higher dividend yield than Stock X.
Expert Solution
The correct answer is "b) If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X."
This is true due to the rationale outlined below.
- Stock Y reflects a higher expected return than Stock X (12% vs. 10%); it is the risker of the two investments.
- Since their dividend yields are the same, some other aspect must make Stock Y riskier than Stock X.
- A lower expected capital gains yield (which means less certain cash flows) is a plausible reason for the risk differential.
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