Assume the following: • The investor’s required rate of return is 13.5 percent, • The expected level of earnings at the end of this year (E1) is $6.00, • The retention ratio is 50 percent, • The return on equity (ROE) is 15 percent (that is, it can earn 15 percent on reinvested earnings), and • Similar shares of stock sell at multiples of 16.667 times earnings per share. Questions: a. Determine the expected growth rate for dividends. b. Determine the price/earnings ratio (P/E1) using Equation (10–5a). 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 60 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 P/E ratios?
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