Explanation for answer A: The market price reflects the expectation of market, which will fluctuate around and adjust towards the theoretical model price. If the theoretical price of stock A derived from the model is in fact lower than that of B, the decision of Fund on stock selection based on this criteria would come up with a wrong decision.
Explanation for answer B: if both A and B pay the same dividend, $10 per share, and A grows by 5% as compared to B by 8%. Based on the constant growth mode as follows:
Theoretical value of stock = current dividend x (1 + growth rate of stock) / (required rate of return of stock - growth rate of stock)
Beta is a part of the required rate of return based on the CAPM, i.e. risk free rate + beta x (rate of market return - risk free rate); the lower the beta is, the lower the required return will be. Since there is a difference of 3% (8% - 5) %) in the growth rates between stock A and stock B it means the Fund must require a required rate of return of stock A at least 3% lower than that of stock B but cannot be more than 4% since the growth rate of stock A is 5%. The theoretical price based on the required rate at 5% or higher would be invalid.
Explanation for answer C: seems contradictory to the Fund's requirement. If stock is a better buy, the Fund needs not consider other factors of stock A which would gain it's attraction for investment.
Explanation for answer D: On contrary to answer B, if beta of stock B is lower, a required return of stock B would become lower. As the rate of return is lower and the growth rate is higher, compared to that of stock A, the price of stock B would be more attractive, the Fund needs only to consider stock B. Thus, this is not a correct answer.
If a stock has a lower beta, it means it's less sensitive to market movements. In other words, it's considered less risky in relation to the market. As a result, investors will require a lower return for holding this stock, because they're taking on less risk.
Conversely, a stock with a higher beta is considered more sensitive to market movements and is perceived as riskier. Investors will demand a higher return to compensate for this additional risk.
A has a lower beta compared to Company B. This means that Company A is considered less risky in relation to the market. As a result, the required rate of return for Company A would be lower than that for Company B.
Given this information, and assuming everything else is equal, a lower required rate of return can make Company A more attractive to investors, even if it has a lower expected dividend growth rate compared to Company B.
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