Question

Castles in the Sand generates a rate of return of 10% on its investments and maintains a plowback ratio of 0.20. Its earnings this year will be $4 per share. Investors expect a rate of return of 8% on the stock.

a. Find the price and P/E ratio of the firm. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

b. Find the price and P/E ratio of the firm if the plowback ratio is reduced to 0.10. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Answer 1

	Castles
	Rate of Return on Investment=(ROE)	10%
	Plowback Ratio	0.2
	Earnings Per Share	$       4.00
	Expected rate of Retun=r	8%
	Gordon Gowth Model Formula:
	Price=(EPS*(1-Plowback))/(r-g)
	g=growth=ROE*Plowback ratio
	g=(10%*.20)	0.02
	Price=(4*(1-.20))/(.08-.02)	$    53.33
	Price Earning Ratio=Market Price per share/Earnings per share
	Price Earning Ratio=53.33/4	13.33
	If Plowback ratio=.20
	Growth rate=ROE*Plowback Ratio
	Growth rate=.10*.10	0.01
	r=	8%
	Price=(4*(1-.10))/(.08-.01)	$    51.43
	Price Earning Ratio=Market Price per share/Earnings per share
	Price Earning Ratio=51.43/4	$    12.86