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Question 1 Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT: A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% Answer These two stocks must have the same dividend yield. These two stocks should have the same expected return. These two stocks must have the same expected capital gains yield. These two stocks must have the same expected year-end dividend. These two stocks should have the same price. Question 2 Which of the following statements is CORRECT? Answer If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%. The stock valuation model, P0 = D1/(rs – g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years. Question 3 The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? Answer If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. The stocks must sell for the same price. Stock Y must have a higher dividend yield than Stock X. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.