Question

Answer this question based on the discounted dividend model. If you expect the market rate of return to increase across the board on all equity securities, then you should also expect:

A) an increase in all stock values.

B) a decrease in all stock values.

C) all stock values to remain constant.

D) dividend-paying stocks to increase in price while non-dividend paying stocks decrease in value.

E) dividend-paying stocks to maintain a constant price while non-dividend paying stocks decrease in value.

Answer 1

When the market rate of return increases using CAPM formula, Expected return on equity = Risk free rate + Beta * market risk premium, the market risk premium increases thus increasing the cost of equity for all stocks. For dividend paying stocks, the dividend discount model for Equity valuation is D0*(1+g)/(k-g) where k is the cost of equity. As cost of equity increases the value of stock will decrease. However, for non dividend paying stock too, valuation using FCFE model will decrease the value per share.

Answer is B) A decrease in all stock values.