Question

A firm has a plowback (retention) rate of 40% and a ROE equal to 10%. The EPS for next
year is estimated at €4 per share and the required rate of return is 8%. What is the share’s
fair price today?

Answer 1

Given,

Retention ratio = 40% or 0.40

ROE = 10% or 0 .10

Expected EPS = 4

Required rate of return = 8% or 0.08

Solution :-

Growth rate = ROE x retention ratio

= 0.10 x 0.40 = 0.04

Expected dividend = expected EPS x (1 - retention ratio)

= 4 x (1 - 0.40)

= 4 x 0.60 = 2.4

Share price = expected dividend (required rate of return - growth rate)

= 2.4 (0.08 - 0.04)

= 2.4 0.04 = 60