Question

In: Finance

The following are associated with an increase in the required rate of return on the equity...

The following are associated with an increase in the required rate of return on the equity investment except

A.

a one-time increase in the constant growth rate.

B.

an increase in the dividend paid.

C.

an increase in the current price of the stock.

D.

a decrease in the current price of the stock.

Expert Solution

The required rate of return is the minimum rate of return acceptable to the investor for owning the equity investment.

Using Gordon Growth Model Required Rate of Return (RRR) = D₁/P₀ + g

Where,

D₁ = next year’s expected annual dividend

P₀ = Current Market Price of the stock

g = expected dividend growth rate

Let us consider the options one by one.

Option A: a one-time increase in the constant growth rate.

In the calculation of the RRR the growth rate is added. Thus, increase in growth rate will increase the RRR.

Option B: an increase in the dividend paid.

In calculation of the RRR dividend paid is in numerator. Increase in numerator will increase the value of fraction D₁/P₀. Thus, increase in the numerator will increase the RRR.

Option C: an increase in the current price of the stock.

In the calculation of the RRR current market price is in the denominator. Increase in denominator will decrease the value of fraction D₁/P₀. Thus, increase in current price of the stock will decrease the RRR.

Option D: a decrease in the current price of the stock.

In the calculation of the RRR current market price is in the denominator. Decrease in denominator will increase the value of fraction D₁/P₀. Thus, decrease in current price of the stock will increase the RRR.

Thus, Option C "an increase in the current price of the stock." is the correct answer.

jeff jeffy answered 1 year ago

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