Question

4. Currently, the dividend-payout ratio (D/E) for the aggregate market is 60 percent, the required return (k) is 11 percent, and the expected growth rate for dividends (g) is 5 percent. a. Compute the current earnings multiplier b. You expect the D/E payout ratio to decline to 50 percent, but you assume there will be no other changes. What will be the P/E? c. Starting with the initial conditions, you expect the dividend-payout ratio to be constant, the rate of inflation to increase by 3 percent, and the growth rate to increase by 2 percent. Compute the expected P/E. d. Starting with the initial conditions, you expect the dividend-payout ratio to be constant, the rate of inflation to decline by 3 percent, and the growth rate to decline by 1 percent. Compute the expected P/E.

Answer 1

a) Earnings multiplier (P/E)

P/E =

where,

D1 = dividend expected at end of period 1 = D(1+g)

E1 = Earnings expected at the end pf period 1

D1/E1 = Dividend payout ratio = 0.6

k = required rate of return = 0.11

g = expected growth rate of dividends = 0.05

So, P/E = 0.6 / (0.11 - 0.05) = 10

b) If D/E declines to 50% then

P/E = 0.5 / (0.11 - 0.05) = 8.33

c) Inc in inflation = 3%

Inc in growth rate = 2%

So, New Required rate of return = 14.33%

New growth rate = 7%

Expected P/E = 0.6 / (0.14 - 0.07) = 8.185

d) Dec in inflation = 3%

Dec in growth rate = 1%

So, New Required rate of return = 7.67%

New growth rate = 4%

Expected P/E = 0.6 / (0.0767 - 0.04) = 16.348

Note: Please let me know if any calculation part is not clear