Question

Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $952,000. Without new projects, both firms will continue to generate earnings of $952,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 12 percent.

a. What is the current PE ratio for each company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

PE ratio ______ times

b. Pacific Energy Company has a new project that will generate additional earnings of $102,000 each year in perpetuity. Calculate the new PE ratio of the company. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

PE ratio _____ times

c. U.S. Bluechips has a new project that will increase earnings by $202,000 each year in perpetuity. Calculate the new PE ratio of the company. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

PE ratio _____ times

Answer 1

PE Ratio Formula = Market price / Earnings

1. PE Ratio if no additional earnings are generated

Market Price = Current Earnings / Return = $952000 / 12% = $7933333.33

PE Ratio = Market price / Earnings = $7933333.33 / $952000 = 8.33

2. PE Ratio if additional earnings of $102000 is generated

Market Price = Current Earnings / Return = ($952000 + $102000) / 12% = $8783333.33

PE Ratio = Market price / Earnings = $8783333.33 / $1054000 = 8.33

3. PE Ratio if additional earnings of $202000 is generated

Market Price = Current Earnings / Return = ($952000 + $202000) / 12% = $9616666.67

PE Ratio = Market price / Earnings = $9616666.67 / $1154000 = 8.33

There won't be any change in PE ratio as long as the additional earnings are in perpetuity