Question

Critical thinking problem: Please choose the answer MOST LIKELY to be true. In a few sentences, explain

why.

You are considering buying the stocks of two companies that operate in the same industry; they have

very similar characteristics except for their dividend payout policies. Both companies are expected to

earn $6 per share this year. However, Company D (for “dividend”) is expected to pay out all of its

earnings as dividends, while Company G (for “growth”) is expected to pay out only one-third of its

earnings, or $2 per share. D’s stock price is $40. G and D 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. Therefore, G’s stock price should be

greater than $40.

b. Although G’s growth rate should exceed D’s, D’s current dividend exceeds that of G, and this should

cause D’s price to exceed G’s.

c. An investor in Stock 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.

d. D’s expected and required rate of return is 15%. G’s expected return will be higher because of its

higher expected growth rate.

e. If we observe that G’s price is also $40, the best estimate of G’s growth rate is 10 percent.

Answer 1

when a company retains part of its profit to plough back for expansion or other purposes then return it will fetch in future will be higher because of its expected growth rate. SO option D is true. other options do not justify because when a company pays dividend regularly and does not retain for expansion then the return is high in short term but in the long term it stagnates and then shareholders can no longer benefit or have opportunity to gain higher returns.