If the spread between the required rate of return on a stock and the dividend growth rate decreases, the price of the stock:
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A. B. C. D.Explanation
In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). When k - g decreases, all else equal, the stock price rises.
The relationship between the required rate of return on a stock and the dividend growth rate is crucial in determining the price of the stock. Let's analyze the given statement and its impact on the stock price:
"If the spread between the required rate of return on a stock and the dividend growth rate decreases..."
To understand this statement, let's break it down into its components:
Required Rate of Return: The required rate of return, also known as the investor's expected return, is the minimum return that an investor expects to receive for taking on the risk of investing in a particular stock. It is influenced by various factors such as the risk-free rate, market risk premium, and company-specific risk.
Dividend Growth Rate: The dividend growth rate represents the annualized rate at which a company's dividends are expected to increase over time. It is influenced by the company's profitability, earnings growth, and dividend policy.
Spread: The spread refers to the difference between the required rate of return and the dividend growth rate. A higher spread indicates that investors require a higher return compared to the expected growth in dividends, reflecting higher perceived risk associated with the stock.
Now, let's consider the impact of a decreasing spread on the stock price:
When the spread between the required rate of return and the dividend growth rate decreases, it implies that the gap between the investor's expected return and the anticipated growth in dividends narrows. This could happen due to several reasons:
Decreased Investor Risk Perception: A decrease in the spread may suggest that investors perceive the stock as less risky. It could be due to improved company performance, increased market confidence, or reduced uncertainty about future cash flows. This positive change in risk perception may lead to an increase in the stock price.
Increased Investor Demand: A smaller spread may attract more investors to the stock. Investors seeking higher returns relative to the dividend growth rate may find the stock more attractive as the perceived risk decreases. The increased demand for the stock can drive up its price.
Considering these factors, the correct answer to the question would be:
D. increases.
When the spread between the required rate of return and the dividend growth rate decreases, it suggests that the stock price is likely to increase due to improved investor sentiment, decreased perceived risk, and increased investor demand.