Q25. All else equal, if a firm’s return on equity (ROE) increases, the stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely: ffice ffice" />
A) not change.
B) decrease.
C) increase.
Correct answer is C)
Increase in ROE: ROE is a component of g. As g increases, the spread between ke and g, or the P/E denominator, will decrease, and the P/E ratio will increase.
Q26. Assume a company's ROE is 14% and the required return on equity is 13%. All else remaining equal, if there is a decrease in a firm’s retention rate, a stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely:
A) increase.
B) either increase or decrease.
C) decrease.
Correct answer is C)
Increase in dividend payout/reduction in earnings retention. In this case, reduction in earnings retention will likely lower the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a higher rate on new projects than the rate required by the market (ROE > ke), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.
Q27. All else equal, an increase in a company’s growth rate will most likely cause its P/E ratio to:
A) increase.
B) decrease.
C) either increase or decrease.
Correct answer is A)
Increase in g: As g increases, the spread between ke and g, or the P/E denominator, will decrease, and the P/E ratio will increase.
Q28. According to the earnings multiplier model, all else equal, as the dividend payout ratio on a stock increases, the:
A) P/E ratio will decrease.
B) P/E ratio will increase.
C) required return on the stock will decrease.
Correct answer is B)
According to the earnings multiplier model, the P/E ratio is equal to P0/E1 = (D1/E1)/(ke - g). As D1/E1 increases, P0/E1 will increase, all else equal.
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