There are two companies, AA and BB, each with current annual earnings of $2 per share. AA trades for $20 per share and BB trades for $30 per share.(b) Assume AA and BB are both priced e?ciently and according to the constant dividend growth model. If both stocks pay half their earnings as an annual dividend, and both stock’s earnings grow at an average rate 3% per year forever, what is the expected return for AA and BB over the next year?
(c) Assume, as in (b), that BB is priced correctly according to the constant dividend growth model, that BB pays half their earnings as an annual dividend, and that its earnings grow at an average rate of 3% per year forever. But now assume that AA is underpriced because markets are making a mistake, and should be priced identically to BB. Moreover, imagine markets will realize their mistake over the next year so that the price of AA equals the price of BB one year from now. In this case, compute the expected return from investing in AA and BB over the next year: