Critical thinking problem: Please choose the answer MOST LIKELY to be true. In a few sentences, explain why.
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 $6 per share this year. However, 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 $2 per share. D’s stock price is $40. G and D are equally risky. Which of the following 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 $40.
b. Although G’s growth rate should exceed D’s, D’s current dividend exceeds that of G, and this should cause D’s price to exceed G’s.
c. An 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.
d. D’s expected and required rate of return is 15%. G’s expected return will be higher because of its higher expected growth rate.
e. If we observe that G’s price is also $40, the best estimate of G’s growth rate is 10 percent.