LOS g: Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends.

Q1. Which of the following does NOT directly affect a company’s required return on equity?

A)   The company’s beta.

B)   Expected market return.

C)   Return on assets.

Q2. Regarding a standard dividend discount model (DDM) which of the following factors is least likely to affect the required rate of return on the investment?

A)   Expected inflation rate.

B)   ROA.

C)   Risk-free rate of return.

Q3. A stock’s dividend growth rate is a function of each of the following EXCEPT:

A)   profit margin.

B)   P/E ratio.

C)   total asset turnover.

Q4. A company’s growth rate in dividends and earnings can be estimated as the:

A)   difference between the retention ratio and the return on equity.

B)   product of the retention ratio and the return on equity.

C)   product of the return on equity and the dividend payout ratio.

Q5. The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT:

A)   the stock's appropriate risk premium.

B)   the stock's dividend payout ratio.

C)   the expected inflation rate.

Q6. The capital asset pricing model can be used to estimate which of the following inputs to the dividend discount model?

A)   The expected inflation rate.

B)   The expected growth rate in dividends.

C)   The required return on equity.

LOS g: Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends.fficeffice" />

Q1. Which of the following does NOT directly affect a company’s required return on equity?

A)   The company’s beta.

B)   Expected market return.

C)   Return on assets.

Correct answer is C)

The formula for the required return is k_e = risk free rate + beta × (market rate – risk free rate).

Q2. Regarding a standard dividend discount model (DDM) which of the following factors is least likely to affect the required rate of return on the investment?

A)   Expected inflation rate.

B)   ROA.

C)   Risk-free rate of return.

Correct answer is B)

The CAPM formula for K_e = R_f + Beta × (R_m ? R_f), where R_f is the (nominal) risk-free rate of return and R_m is the market rate of return. The (nominal) risk-free rate = [(1 + real risk-free rate) × (1 + inflation rate)] ? 1.

Q3. A stock’s dividend growth rate is a function of each of the following EXCEPT:

A)   profit margin.

B)   P/E ratio.

C)   total asset turnover.

Correct answer is B)

Assuming past investments are stable and earnings are calculated to allow for maintenance of past earnings power, then the firm’s expected dividend growth rate (g) can be defined as the firm’s earnings plowback or retention rate (RR) times the return on the equity (ROE) portion of new investment. RR is equal to 1 minus the dividend payout ratio, and ROE equals profit margin times total asset turnover times financial leverage. This growth rate is also called the sustainable growth rate.

Q4. A company’s growth rate in dividends and earnings can be estimated as the:

A)   difference between the retention ratio and the return on equity.

B)   product of the retention ratio and the return on equity.

C)   product of the return on equity and the dividend payout ratio.

Correct answer is B)

Assuming past investments are stable and earnings are calculated to allow for maintenance of past earnings power, then the firm’s expected dividend growth rate (g) can be defined as the firm’s earnings plowback or retention rate (RR) times the return on the equity (ROE) portion of new investments. This growth rate is also called the sustainable growth rate.

Q5. The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT:

A)   the stock's appropriate risk premium.

B)   the stock's dividend payout ratio.

C)   the expected inflation rate.

Correct answer is B)

A stock’s required rate of return is equal to the nominal risk-free rate plus a risk premium. The nominal risk-free rate is approximately equal the real risk-free rate plus expected inflation.

Q6. The capital asset pricing model can be used to estimate which of the following inputs to the dividend discount model?

A)   The expected inflation rate.

B)   The expected growth rate in dividends.

C)   The required return on equity.

Correct answer is C)        

The capital asset pricing model is a rate of return model that can be used to estimate a stock’s required rate of return, given the nominal risk-free rate, the market risk premium, and the stock’s beta: k = R_{nominal risk free rate} + (beta)(R_market - R_{nominal risk free rate}).

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