Question

You have been reading about the Madison Computer Company (MCC), which currently retains 88 percent of its earnings ($5 a share this year). It earns an ROE of almost 34 percent.

1. Assuming a required rate of return of 15 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 58 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

a). Dividend = EPS * (1 - Retention Ratio) = $5 * (1 - 0.88) = $0.6

g = ROE*b = 34%*0.88 = 29.92%

P/E = D/E/( k -g ) = 0.12/(0.15-0.2992)

Since the required rate of return (k) is less than the growth rate (g), the earnings multiplier cannot be used (the answer is meaningless)

b). Dividend = EPS * (1 - Retention Ratio) = $5 * (1 - 0.58) = $2.1

g = ROE*b = 15%*0.58 = 8.7%

P/E = D/E/( k -g ) = 0.42/(0.15-0.087) = 6.67 times

If next year’s earnings are expected to be = EPS * (1 + g)

= $5.00*(1 + 0.087) = $5.435

Applying the P/E:

Price = P/E * E1 = 6.67 * $5.435 = $36.23

Thus, you would be willing to pay $36.23 for Maddy Computer Company stock.