STOCK GROWTH RATES AND VALUATION 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 $3 per share this year; but 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 $1 per share. D’s stock price is $25. G and D are equally risky. Which of the following statements 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 $25.

b. Although G’s growth rate should exceed D’s, D’s current dividend exceeds that of G, which should cause D’s price to exceed G’s.

c. A long-term 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. Therefore, if economic shifts cause rd and rs to increase, and if the expected dividend streams from D and G remain constant, both Stocks D and G will decline, but D’s price should decline further.

d. D’s expected and required rate of return is ^rs rs 12%. G’s expected return will be higher because of its higher expected growth rate.

e. If we observe that G’s price is also $25, the best estimate of G’s growth rate is 8%.

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