Question

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is correct? (Hint: Use the SML equation to calculate each stock’s required rate of return)a. Stock A must have a higher stock price than Stock B.b. Stock A must have a higher dividend yield than Stock B.c. Stock B’s dividend yield equals its expected dividend growth rate.d. Stock B must have the higher required return.e. Stock B could have the higher expected return

Answer 1

Answer: b. Stock A must have a higher dividend yield than Stock B.

Explanation:

The missing information has been attached.

Using the Security Market Line requires rising the Capital Asset Pricing Model to calculate expected returns.

The formula is,

Expected return = Risk free rate + beta(market premium)

Stock A

= 6.4% + 1.10 (6.0%)

= 13%

Stock B

= 6.4% + 0.9(6.0%)

= 11.8%

The Expected return of a stock is the result of either of 2 things. It could be the Dividend yield or the Capital Gains Yield.

The Capital Gains Yield is as a result of the growth of the company. The growth rate is listed as 7% for both so it is the same.

The Dividend yield must be the differnt one so Stock As Dividend yield must be higher to yield a huge expected return making Option B. correct.