- CFA Exams
- CFA Level I Exam
- Study Session 13. Equity Investments (2)
- Reading 41. Equity Valuation: Concepts and Basic Tools
- Subject 2. Present Value Models: The Dividend Discount Model

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**CFA Practice Question**

The preferred stock of the Wordsworth Institute pays a constant annual dividend of $3.00 and sells for $20.00. You believe the stock will sell for $12.00 in one year. You must, therefore, believe that the required return on the stock will be which of the following percentage points (lower/higher) in one year?

B. It will be 8.0% higher.

C. It will be 10.0% higher.

A. It will be 8.0% lower.

B. It will be 8.0% higher.

C. It will be 10.0% higher.

Correct Answer: C

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**User Contributed Comments**
14

User |
Comment |
---|---|

cgeek |
how to get this answer? why $20 for this year and $12 in one year |

jamiejamie |
first, solve for k at time t0 = 15% then, solve for k at time t1 = 25% you get these values using the preferred stock value (preferred stock value = dividend/k) then, you know that there is an INCREASE of 10% (25%-15%) Intuitively, you know that if you get the same dividend for a cheaper security price, then your K must have risen. |

stefdunk |
the 10% increase is not in the value of the stock, but in the rate of return you expect. You want a higher payout, so the value of the share will drop (preferred stocks and bonds: value drops if payout % rises) |

katybo |
D/K = 3/0.25 = 12 -> 0.25-0.15 = 10% |

haarlemmer |
Sine the dividend is constant, the answer is then (3/12)-(3/20)=10% |

Done |
think about it like it was a bond. since the price went down the yield should go up. That eliminates A and D, then do the math |

faya |
If 3/k=20 => k=15%; If 3/k=12 => k=25%. Therefore, to get 3/k=12, you need to increase k by 10% |

cfahanoi |
k increase => P reduce 3/12 - 3/20 = 10% |

accounting |
go for cfahanoi |

VenkatB |
jamiejamie - thanks for the explanation. |

jansen1979 |
t0: $ 20 = $ 3/x => x = 15% t1: $ 12 = $ 3/x => x = 25% Increase of 10% |

bundy |
3/12 = 25 3/20 = 15 therefore 10% higher |

loisliu88 |
cost of preferred stock=D/r, r0= D/P0, r1= D/p1 |

2014 |
Good work bundy |