Question

true or false

A). The constant dividend growth model assumes that the cost of equity is smaller than the dividend growth rate.

B). Consumer staples excel in the economic downturn.

C). The cyclical indicator approach covers all important major economic sectors including the service sector and import-exports.

D). A larger spread between bonds with high default risk and low default risk indicates the economy is not in a good shape.

Answer 1

A]

False. the model assumes that dividend growth rate is smaller than the cost of equity

In constant dividend growth model, value of share = dividend at end of next year / (cost of equity - dividend growth rate)

If dividend growth rate > cost of equity, then the value of the share would be negative, which is meaningless. Hence this model assumes that dividend growth rate is smaller than the cost of equity

B]

True. During an economic downturn, consumer staples are usually the safer sectors to invest in. This is because the demand for consumer staples is relatively stable and does not change sharply with economic cycles.

C] True. The cyclical indicator approach covers all important major economic sectors. The data collected is analysed and leading indicators are constructed to forecast economic cycles

D]

True. During an economic downturn, the risk of default is higher. Hence, investor prefer safer Treasury bonds. This drives the yields of Treasury bonds lower, and the yields of lower-rated bonds higher. Hence the spreads increase