Question

Question

Turner Compacts Ltd. is expected to pay a $2 dividend in one year. The required rate of return is 9 percent. The firm uses a dividend payout ratio of 25 percent. Calculate the leading P/E ratio in the following cases:

a. Expected growth rate = 4 percent

                i. Today

                ii. In one year (immediately after dividend paid)

b. Expected growth rate = 8 percent

                i. Today

                ii. In one ear (immediately after dividend paid)

c. If a firm is expected to have a constant dividend growth rate, do you expect the P/E ratio to change over time? Explain.

Answer 1

a)i). P0 = D1 / (r - g)

= $2 / (0.09 - 0.04) = $2 / 0.05 = $40

E1 = D1 / DPR = $2 / 0.25 = $8

Leading P/E = P0 / E1 = $40 / $8 = 5

ii). P1 = D2 / (r - g)

= $2(1.04) / (0.09 - 0.04) = $2.08 / 0.05 = $41.60

E2 = D2 / DPR = $2.08 / 0.25 = $8.32

Leading P/E (in one year) = P1 / E2 = $41.60 / $8.32 = 5

b)i). P0 = D1 / (r - g)

= $2 / (0.09 - 0.08) = $2 / 0.01 = $200

E1 = D1 / DPR = $2 / 0.25 = $8

Leading P/E = P0 / E1 = $200 / $8 = 25

ii). P1 = D2 / (r - g)

= $2(1.04) / (0.09 - 0.08) = $2.08 / 0.01 = $208

E2 = D2 / DPR = $2.08 / 0.25 = $8.32

Leading P/E (in one year) = P1 / E2 = $208 / $8.32 = 25

c).