Question content area top Part 1 ​(Common stock​ valuation)  Assume the​ following:   •   the​ investor's required rate of return is 14.5 ​percent, •   the expected level of earnings at the end of this year ​(E1​) is ​$6​, •   the retention ratio is 40 ​percent, •   the return on equity ​(ROE​) is 14 percent​ (that is, it can earn 14 percent on reinvested​ earnings), and •   similar shares of stock sell at multiples of 6.742 times earnings per share.   ​Questions:   a.  Determine the expected growth rate for dividends. b.  Determine the price earnings ratio ​(P​/E1​). c.  What is the stock price using the ​P/E ratio valuation​ method?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Question content area top

Part 1
​(Common stock​ valuation)  Assume the​ following:
 
•  
the​ investor's required rate of return is
14.5
​percent,
•  
the expected level of earnings at the end of this year
​(E1​)
is
​$6​,
•  
the retention ratio is
40
​percent,
•  
the return on equity
​(ROE​)
is
14
percent​ (that is, it can earn
14
percent on reinvested​ earnings), and
•  
similar shares of stock sell at multiples of
6.742
times earnings per share.
 
​Questions:
 
a.  Determine the expected growth rate for dividends.
b.  Determine the price earnings ratio
​(P​/E1​).
c.  What is the stock price using the ​P/E ratio valuation​ method?
d.  What is the stock price using the dividend discount​ model?
e.  What would happen to the ​P/E ratio
​(P​/E1​)
and stock price if the company increased its retention rate to
80
percent​ (holding all else​ constant)? What would happen to the ​P/E ratio
​(P​/E1​)
and stock price if the company paid out all its earnings in the form of​ dividends?
f.  What have you learned about the relationship between the retention rate and the ​P/E​ ratios?
 
 
 

Question content area bottom

Part 1
a.  What is the expected growth rate for​ dividends?
 
enter your response here​%
​ (Round to two decimal​ places.)
Part 2
b.  What is the price earnings ratio
​(P​/E1​)?
 
enter your response here
​ (Round to three decimal​ places.)
Part 3
c.  What is the stock price using the ​P/E ratio valuation​ method?
 
​$enter your response here
​ (Round to the nearest​ cent.)
Part 4
d.  What is the stock price using the dividend discount​ model?
 
​$enter your response here
​ (Round to the nearest​ cent.)
Part 5
e.​ (i)  Using the dividend discount​ model, what would be the stock price if the company increased its retention rate to
80​%
​(holding all else​ constant)?
 
​$enter your response here  
​(Round to the nearest​ cent.)
Part 6
What would be the ​P/E ratio
​(P​/E1​)
if the company increased its retention ratio to
80​%
​(holding all else​ constant)?  
 
enter your response here  
​(Round to three decimal​ places.)
Part 7
e.​ (ii)  Using the dividend discount​ model, what would be stock price if the company paid out all its earnings in the form of​ dividends?
 
​$enter your response here  
​(Round to the nearest​ cent.)
Part 8
What would be the ​P/E ratio
​(P​/E1​)
and stock price if the company paid out all its earnings in the form of​ dividends?
 
enter your response here  
​(Round to three decimal​ places.)
Part 9
f.  What have you learned about the relationship between the retention ratio and the ​P/E​ ratio?  ​(Select from the​ drop-down menus.)
 
Assume that the​ investor's required rate of return is greater than the dividend growth​ rate, the higher the retention​ ratio, other things being the​ same, the
 
lower
higher
the value of the common stock and thus the
 
lower
higher
the price earnings​ ratio,
​P/E.
 
 
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