Question

# (Ordinary share valuation) Assume the following: • the investor’s required rate of return is 15% •...

(Ordinary share valuation) Assume the following:
• the investor’s required rate of return is 15%
• the expected level of earnings at the end of this year (E|) is \$5.00
• the retention ratio is 50% • the return on equity (ROE) is 20% (i.e. it can earn 20% on reinvested earnings)
• similar shares sell at multiples of 10 times earnings per share.

Questions:

(a) Determine the expected growth rate for dividends.

(b) Determine the price/earnings ratio (P!E\) using equation.

(c) What is the share price using the P/E ratio valuation method?

(d) What is the share price using the dividend discount model?

(e) What would happen to the P/E ratio (P!E\) and share price if the firm could earn 25% on reinvested earnings (ROE)?

(f) What does this tell you about the relationship between the rate the firm can earn on reinvested earnings and P/E ratios?

Using the correct formulas, not excel calculators/cells

 a) Growth Rate = ROE x Plowback ratio Growth Rate = 20% x 50% 10.00% b) P0 = DIV1/(r-g) DIV 1 = E1 x ( 1 - 50%) \$2.50 P0 = \$2.50/(15% - 10%) \$50.00 P/ E = \$50/\$5 10.00 Times c) P/E = Price / EPS = 10 = Price/\$5 Price = 10 x \$5 \$50.00 d) P0 = DIV1/(r-g) DIV 1 = E1 x ( 1 - 50%) \$2.50 P0 = \$2.50/(15% - 10%) \$50.00 e) Growth Rate = ROE x Plowback ratio Growth Rate = 25% x 50% 12.50% P0 = DIV1/(r-g) DIV 1 = E1 x ( 1 - 50%) \$2.50 P0 = \$2.50/(15% - 12.50%) \$100.00 P/ E = \$100/\$5 20.00 Times f) The ROE increases, then growth rate also increases and PE ratio increases as the return on equity increases and decreases as the return on equity decreases.

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