Question

Which assertion about the prices of stocks Kilo, Lima, Mike, and November is true? All 4 stocks pay annual dividends with the next dividend expected 1 year. The next expected dividend for stocks Kilo and Mike are expected to be different, as DM > DK > 0, and the next expected dividend for stocks November and Lima are expected to be the same. The dividends for each stock are expected to grow at a constant rate of G forever. The expected returns for stocks November and Lima are expected to be different, as RN > RL > 0, and the expected returns for stocks Kilo and Lima are expected to be the same. Finally, D > 0, R > 0, and G > 0.

	A.	The price of stock Kilo is greater than the price of stock Mike and the price of stock Lima is greater than the price of stock November.
	B.	Answer not listed or not possible.
	C.	The price of stock Mike is greater than the price of stock Kilo and the price of stock November is greater than the price of stock Lima.
	D.	The price of stock Kilo is greater than the price of stock Mike and the price of stock November is greater than the price of stock Lima.
	E.	The price of stock Mike is greater than the price of stock Kilo and the price of stock Lima is greater than the price of stock November.

Answer 1

Answer E

The price of stock Mike is greater than the price of stock Kilo and the price of stock Lima is greater than the price of stock November.

The price of a stock growing at a constant rate forever, using Dividend discount model is given by

= D1 / (K-g) ,

where D1= Expected dividend next year

k = Expected Return from the stock

g = Forever Growth rate

As per the given assumptions we can construct the following table for our understanding for the pair of stocks Kilo & Mike

	Kilo	Mike	Explanation
D1	3	5	Assumption that Expected dividend for Dm > Dk (5 & 3 are just assumed to make an understanding
R	b	b	Assumption that Expected growth for Rm = Rk =b
G	g	g	Assumption that forever growth is same for Gm = Gk = g
Price	=3/(b-g)	=5/(b-g)	Using The DDM formula and assumed values

Here, while denominator is same, numerator for Mike is higher.

Thus price of stock of MIke will be higher than stock price of stock of Kilo

Similarly for other pair of stock Lima & November

	November	Lima	Explanation
D1	a	a	Assumption that Expected dividend is same for Dn = Dl= a
R	12%	10%	Assumption that Expected growth for Rn > Rl (12% & 10% are just assumptions to better understand)
G	g	g	Assumption that forever growth is same for Gn = Gl = g
Price	=a/(12%-g)	=a/(10%-g)	Using The DDM formula and assumed values

In this case the numerator is same for both stock, but denominator of November would be higher.

As Price would Inversely related to denominator (12% -g) or (10% -g)

Stock Price of Lima would be higher than stock price of November