We are going to explore the differences between two different companies, both from the same sector, firms A and B. They differ in their reinvestment abilities. Firm A and Firm B are both financed with equity only. At the end of their business year, both firms report $1,000m in revenue. The net income is $200m for both firms. Assume that management is able to maintain a constant net profit margin of 20%. • Firm A is capable of achieving 8% revenue growth annually by investing 27% of their net income. . Firm B is capable of achieving 8% revenue growth annually by investing 40% of their net income. Assume that this difference persists into the future. a) Find the value of firms A and B. Use a discount rate of 16% for both firms. Value of firm A in millions: Value of firm B in millions: b) The forward P/E ratio of a company is the price of a share divided by next year's earnings per share, or its value divided by next year's earnings. What is the forward P/E ratio of firms A and B? P/E ratio of firm A: P/E ratio of firm B: c) Why is the forward P/E ratio higher for firm A? Or said differently: Why would shares of firm A be more expensive? Firm A is able to generate the same degree of growth at a reinvestment rate. Therefore, the present value of their growth is
We are going to explore the differences between two different companies, both from the same sector, firms A and B. They differ in their reinvestment abilities. Firm A and Firm B are both financed with equity only. At the end of their business year, both firms report $1,000m in revenue. The net income is $200m for both firms. Assume that management is able to maintain a constant net profit margin of 20%. • Firm A is capable of achieving 8% revenue growth annually by investing 27% of their net income. . Firm B is capable of achieving 8% revenue growth annually by investing 40% of their net income. Assume that this difference persists into the future. a) Find the value of firms A and B. Use a discount rate of 16% for both firms. Value of firm A in millions: Value of firm B in millions: b) The forward P/E ratio of a company is the price of a share divided by next year's earnings per share, or its value divided by next year's earnings. What is the forward P/E ratio of firms A and B? P/E ratio of firm A: P/E ratio of firm B: c) Why is the forward P/E ratio higher for firm A? Or said differently: Why would shares of firm A be more expensive? Firm A is able to generate the same degree of growth at a reinvestment rate. Therefore, the present value of their growth is
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
Problem 1PS
Related questions
Question
Transcribed Image Text:We are going to explore the differences between two different companies, both from
the same sector, firms A and B. They differ in their reinvestment abilities. Firm A and
Firm B are both financed with equity only.
At the end of their business year, both firms report $1,000m in revenue. The net
income is $200m for both firms. Assume that management is able to maintain a
constant net profit margin of 20%.
• Firm A is capable of achieving 8% revenue growth annually by investing 27% of
their net income.
.
Firm B is capable of achieving 8% revenue growth annually by investing 40% of
their net income.
Assume that this difference persists into the future.
a) Find the value of firms A and B. Use a discount rate of 16% for both firms.
Value of firm A in millions:
Value of firm B in millions:
b) The forward P/E ratio of a company is the price of a share divided by next year's
earnings per share, or its value divided by next year's earnings. What is the forward
P/E ratio of firms A and B?
P/E ratio of firm A:
P/E ratio of firm B:
c) Why is the forward P/E ratio higher for firm A? Or said differently: Why would shares
of firm A be more expensive?
Firm A is able to generate the same degree of growth at a
reinvestment rate. Therefore, the present value of their growth is
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