Question

You have been reading about the Madison Computer Company (MCC), which currently retains 85 percent of its earnings ($7 a share this year). It earns an ROE of almost 34 percent.

1. Assuming a required rate of return of 14 percent, how much would you pay for MCC on the basis of the earnings multiplier model? Do not round intermediate calculations. Round your answer to the nearest cent. Enter zero if the obtained answer is economically meaningless.

   $  

2. What would you pay for Madison Computer if its retention rate was 56 percent and its ROE was 15 percent? Do not round intermediate calculations. Round your answer to the nearest cent. Enter zero if the obtained answer is economically meaningless.

   $  

Answer 1

Under Earnings Multiplier Method, P= E*(1-b)/r-ROE*b

Where

P= Price per share, E= EPS, r= rate of return, ROE= Return on investment (given as 34%) and b= retention ratio (given as 85%)

Also given, E*85%= $7.

Therefore, EPS = $7/0.85= $8.235294

Part (a):

Give, r= 14%

Plugging the inputs,

Price (P) = (7/0.85)*(1-0.85)/0.14-0.34*0.85

= 1.235294/-0.149 = -$8.29056

Since a negative value for price is economically meaningless, answer is $0

Part (b):

Given b= 56% and r= 15%, other parameters remaining as above.

Price= (7/0.56)*(1-0.56)/0.15-0.34*0.56

=5.5/-0.0404 = -$136.138614

Since a negative value for price is economically meaningless, answer is $0