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  • 1.  plz explain the correct answer

    Posted 06-12-2013 10:23 AM
    Dear All ,

    Can any one plz explain the correct answer

    The Mammoth Mutual Fund uses the Constant Dividend Growth Valuation model to help it decide which stocks to buy. Company A and Company B both pay dividends of $10 a share. Company A's dividend is expected to grow by 5% while Company B's dividend is expected to grow by 8%. Which of the following conditions is necessary for Mammoth to buy Company A rather than Company B?

    correct answer is (b) Company A's beta is lower, so its required rate of return is 4% lower than Company B's

    [Hayam] [Helwa]
    [Senior Accountant]
    [DKT International]

  • 2.  RE:plz explain the correct answer

    Posted 06-12-2013 12:23 PM

    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.

    Total Solution Consultancy (Hangzhou) Limited

  • 3.  RE: plz explain the correct answer

    Posted 09-20-2023 08:20 AM
    • 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.

    United Arab Emirates