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## plz explain the correct answer

• #### 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?

 Company A's stock price is currently higher than the price suggested by the model. Company A's beta is lower, so its required rate of return is 4% lower than Company B's. Company B's stock is always a better buy, because of it higher growth rate. Company B's beta is lower, so its required rate of return is 3% lower than Company A's.

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

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[Hayam] [Helwa]
[Senior Accountant]
[DKT International]
[Cairo]
[Egypt]
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• #### 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.

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Kam Sing LEUNG CFP, CPA, FCCA
Controller
Total Solution Consultancy (Hangzhou) Limited
Hangzhou
China
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• #### 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.

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SHAIBAN AHMED HAJI FAQUIH
Accountant
DUBAI
United Arab Emirates
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