Question

5.5 Firm X is priced at $10 per share. Expected dividend next year is $1 per share, and the expected stock price next year is $11. Therefore, stock is expected to earn (11 + 1 – 10)/10 = 20%. This implies that the company has required rate of return that is also 20%. (True / False)

5.6 When ROE < k, increasing _______ should increase the intrinsic value of equity.

              a. Retention ratio

              b. Dividend payout

              c. Dividend growth rate

5.7 Present Value of Growth Opportunities PVGO can never be negative. (True / False)

5.8 Required rate of return on equity can be found from which formula?

              a. CAPM

              b. Gordon’s Model

              c. ROE

              d. Either of the above, depends on what information is provided

5.9 If the company is correctly priced under Gordon’s model, and changing dividend payout policy does not change stock price, it must be that

              a. ROE = k

              b. The company is a cash cow

              c. PVGO > 0

5.10 Growth in dividends can be represented as sustainable growth rate in Gordon’s model. (True / False)

Answer 1

5.5- False, This 20% implies Return on Investment and not the expected return or the required return.

5.6- Dividend Payout- SInce, the Return on Investments is less than the expected return by the shareholders, investing the earnings would not yield sufficient returns to fulfill the shareholder's expectations. Hence, the company should distribute the earnings among the shareholders by way of dividend.

5.7- False. - PVGO can be negative when the Return on Investment on growth opportunities is less than the expected return on equity.

5.8- CAPM-

As per CAPM, k= Rf + Beta (Rm-Rf)

5.9- ROE=k, Dividend payout does not affect price of share means that the company has growth opportunities yielding same returns as expected by the shareholders.

5.10- False. Growth in the Returns on investment are represented as sustainable growth in the Gordon Model.