Kingpin804

If a company has a "0" earnings retention rate, the firm's P/E ratio will equal:

A) k + g

B) 1 / k

C) D/P + g

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P/E = div payout ratio / (k − g)
where g = (retention rate)(ROE) = (0)(ROE) = 0
Dividend payout = 1 − retention ratio = 1 − 0 = 1
P/E = 1 / (k − 0) = 1 / k

Kingpin804

A company currently has a required return on equity of 14% and an ROE of 12%. All else equal, if there is an increase in a firm’s dividend payout ratio, the stock's value will most likely:

A) either increase or decrease.

B) decrease.

C) increase.

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Increase in dividend payout/reduction in earnings retention.In this case, an increase in the dividend payout will likely increase the P/E ratio because a decrease in earnings retention will likely increase 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 lower rate on new projects than the rate required by the market (ROE < ke), investors will likely prefer that the company pay out earnings rather than investing in lower-yield projects. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would rise, as investors will value the company higher if it retains a lower percentage of earnings.

Kingpin804

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:

A) not change.

B) decrease.

C) increase.

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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.

Kingpin804

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.

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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.

Kingpin804

All else equal, an increase in a company’s growth rate will most likely cause its P/E ratio to:

A) decrease.

B) either increase or decrease.

C) increase.

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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.

Kingpin804

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) required return on the stock will decrease.

C) P/E ratio will increase.

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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.

Kingpin804

All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the:

A) dividend payout is decreased.

B) ROE is increased.

C) long-term growth rate is decreased.

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The increase in growth rate will increase the P/E ratio of a stable firm and growth rate can be calculated by the formula g = ROE × retention ratio. All else being equal an increase in ROE will therefore increase the P/E ratio. Note that decreasing the dividend payout ratio and decreasing the long term growth rate will both serve to decrease the P/E ratio.

Kingpin804

Assume the following information for a stock:

Beta coefficient	= 1.50
Risk-free rate	= 6%
Expected rate of return on market	= 14%
Dividend payout ratio	= 30%
Expected dividend growth rate	= 11%

The estimated earnings multiplier (P/E ratio) is closest to:

A) 4.29.

B) 3.33.

C) 10.00.

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P/E = D/E1 / (k − g)
D/E1 = Dividend payout ratio = 0.3
g = 0.11
k = 6 + (1.5)(14 − 6) = 18%
P/E = 0.3 / (0.18 − 0.11) = 0.3 / 0.07 = 4.29

Kingpin804

An analyst gathered the following data for the Parker Corp. for the year ended December 31, 2005:

• EPS2005 = $1.75
• Dividends2005 = $1.40
• Beta Parker = 1.17
• Long-term bond rate = 6.75%
• Rate of return S&P 500 = 12.00%

The firm is expected to continue their dividend policy in future. If the long-term growth rate in earnings and dividends is expected to be 6%, the forward P/E ratio for Parker Corp. will be:

A) 21.54.

B) 11.61.

C) 12.31.

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The required rate of return on equity for Parker will be 12.89% = 6.75% + 1.17(12.00% − 6.75%) and the firm pays 80% (1.40 / 1.75) of its earnings as dividends.
Forward P/E ratio = 0.80 / (0.1289 - 0.0600) = 11.61
Where r = required rate of return on equity, gn = growth rate in dividends (forever).

Kingpin804

An analyst gathered the following data for the Parker Corp. for the year ended December 31, 2005:

• EPS2005 = $1.75
• Dividends2005 = $1.40
• Beta Parker = 1.17
• Long-term bond rate = 6.75%
• Rate of return S&P500 = 12.00%

The firm has changed its dividend policy and now plans to pay out 60% of its earnings as dividends in the future. If the long-term growth rate in earnings and dividends is expected to be 5%, the appropriate price to earnings (P/E) ratio for Parker will be:

A) 9.14.

B) 7.98.

C) 7.60.

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Required rate of return on equity will be 12.89% = 6.75% + 1.17(12.00% - 6.75).
P/E Ratio = 0.60 / (0.1289 - 0.0500) = 7.60.