Question

Which of the following statements is CORRECT, assuming stocks are in equilibrium?

a. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well.
b. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return.
c. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return.
d. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.
e. A stock's dividend yield can never exceed its expected growth rate.

Answer 1

The correct statement is option d, which states that the dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

Step-by-step explanation:

The correct statement among the options provided, assuming stocks are in equilibrium, is d. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. This statement is based on the Gordon Growth Model (also known as the Dividend Discount Model), which is a method used for valuing a stock by assuming that dividends will continue to grow at a constant rate.

Here's the reasoning behind the incorrectness of the other choices:

• a. If the required return is 13% and the dividend growth rate is 5%, the expected dividend yield is not necessarily 5%. It would be whatever yield, in addition to the expected growth, results in a total return of 13%.
• b. Higher beta coefficients indicate higher risk, and thus a higher, not lower, required rate of return.
• c. The constant growth model requires that the stock's expected growth rate must be less than its required rate of return for the model to be valid.
• e. A stock's dividend yield can exceed its expected growth rate in some cases, especially when the price is anticipated to decline or the company distributes a large proportion of earnings as dividends.