Kingpin804

An analyst gathered the following information about an industry. The industry beta is 0.9. The industry profit margin is 8%, the total asset turnover ratio is 1.5, and the leverage multiplier is 2. The dividend payout ratio of the industry is 50%. The risk-free rate is 7% and the expected market return is 15%. The industry P/E is closest to:

A) 12.00.

B) 22.73.

C) 14.20.

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Using the CAPM: ki = 7% + 0.9(0.15 − 0.07) = 14.2%.
Using the DuPont equation: ROE = 8% × 1.5 × 2 = 24%.
g = retention ratio × ROE = 0.50 × 24% = 12%.
P/E = 0.5/(0.142 − 0.12) = 22.73.

Kingpin804

A firm has an expected dividend payout ratio of 48 percent and an expected future growth rate of 8 percent. What should the firm's price to earnings ratio (P/E) be if the required rate of return on stocks of this type is 14 percent and what is the retention ratio of the firm?

P/E ratio

Retention ratio

A) 8.0    52%

B) 6.5    52%

C) 6.5    48%

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P/E = (dividend payout ratio)/(k - g)
P/E = 0.48/(0.14 - 0.08) = 8
The retention ratio = (1 - dividend payout) = (1 - 0.48) = 52%

Kingpin804

All of the following factors affects the firm’s P/E ratio EXCEPT:

A) the required rate of return.

B) growth rates of dividends.

C) the expected interest rate on the bonds of the firm.

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The factors that affect the P/E ratio are the same factors that affect the value of a firm in the infinite growth dividend discount model. The expected interest rate on the bonds is not a significant factor affecting the P/E ratio.

Kingpin804

Assuming all other factors remain unchanged, which of the following would most likely lead to a decrease in the market P/E ratio?

A) A decline in the risk-free rate.

B) An increase in the dividend payout ratio.

C) A rise in the stock risk premium.

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P/E = (1 - RR)/(k - g)
To lower P/E: RR increases, g decreases and or k increases. Both a decline in the RF rate and a decline in the rate of inflation will reduce k. An increase in the stock's risk premium will increase k.

Kingpin804

A stock has a required return of 14% percent, a constant growth rate of 5% and a retention rate of 60%. The firm’s P/E ratio should be:

A) 4.44.

B) 6.66.

C) 5.55.

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P/E = (1 - RR) / (k - g) = 0.4 / (0.14 - 0.05) = 4.44

Kingpin804

If the expected dividend payout ratio of a firm is expected to rise from 50 percent to 55 percent, the cost of equity is expected to increase from 10 percent to 11 percent, and the firm’s growth rate remains at 5 percent, what will happen to the firm’s price-to-equity (P/E) ratio? It will:

A) be unchanged.

B) increase.

C) decline.

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Payout increases from 50% to 55%, cost of equity increases from 10% to 11%, and dividend growth rate stays at 5%, the P/E will change from 10 to 9.16:
P/E = (D/E) / (k – g).

P/E0 = 0.50 / (0.10 – 0.05) = 10.
P/E1 = 0.55 / (0.11 – 0.05) = 9.16.

Kingpin804

A firm has an expected dividend payout ratio of 50 percent, a required rate of return of 18 percent, and an expected dividend growth rate of 3 percent. The firm’s price to earnings ratio (P/E) is:

A) 6.66.

B) 3.33.

C) 2.78.

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P/E = .5 / (18%-3%) = 3.33.

Kingpin804

Which of the following is NOT a determinant of the expected price/earnings (P/E) ratio?

A) Expected dividend payout ratio (D/E).

B) Expected growth rate in dividends (g).

C) Average debt to capital ratio (D/C).

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The P/E ratio is determined by payout ratio D/E, required return Ke, and expected growth g.

Kingpin804

According to the earnings multiplier model, which of the following factors is the least important in estimating a stock’s price-to-earnings ratio? The:

A) historical dividend payout ratio.

B) estimated required rate of return on the stock.

C) expected dividend payout ratio.

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P/E = (D1/E1)/(k - g)
where:
D1/E1 = the expected dividend payout ratio
k = estimated required rate of return on the stock
g =  expected growth rate of dividends for the stock

The P/E is most sensitive to movements in the denominator.

Kingpin804

Use the following information to determine the value of River Gardens’ common stock:

• Expected dividend payout ratio is 45%.
• Expected dividend growth rate is 6.5%.
• River Gardens’ required return is 12.4%.
• Expected earnings per share next year are $3.25.

A) $24.80.

B) $30.12.

C) $27.25.

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First, estimate the price to earnings (P/E) ratio as: (0.45) / (0.124 – 0.065) = 7.63. Then, multiply the expected earnings by the estimated P/E ratio: ($3.25)(7.63) = $24.80.