Question: You are considering buying the stocks of two companies that

You are considering buying the stocks of two companies that operate in the same industry. Both firms have similar characteristics except for their dividend payout policies, and both are expected to earn $6 per share this year. Company D (for “dividend”) is expected to pay out all of its earnings as dividends, whereas Company G (for “growth”) is expected to pay out only one-third of its earnings, or $2 per share. Company D’s stock price is $40. Both firms are equally risky. Which of the following is most likely to be true?
a. Company G will have a faster growth rate than Company D, so G’s stock price should be greater than $40.
b. Although G’s growth rate should exceed D’s growth rate, D’s current dividend exceeds that paid by G, which should cause D’s price to exceed G’s price.
c. An investor in Company D will get his or her money back faster because D pays out more of its earnings as dividends. Thus, in a sense, D is like a short-term bond, and G is like a long-term bond. If economic shifts cause rs to increase, and if the expected streams of dividends from D and G remain constant, the stocks of both companies will decline, but D’s price should decline more.
d. Company D’s expected and required rate of return is rs = rs = 15%. Company G’s expected return will be higher because of its higher expected growth rate.
e. On the basis of the available information, the best estimate of G’s growth rate is 10 percent.

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  • CreatedNovember 24, 2014
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