(Valuing common stock) Assume the following:

• The investor’s required rate of return is 13.5 percent.

• The expected level of earnings at the end of this year (E1) is $6.00.

• The retention ratio is 50 percent.

• The return on equity (ROE) is 15 percent (that is, it can earn 15 percent on reinvested earnings).

• Similar shares of stock sell at multiples of 16.667 times earnings per share.

a. Determine the expected growth rate for dividends.

b. Determine the price/earnings ratio (P/E1) using Equation (10–5a).

c. What is the stock price using the P/E ratio valuation method?

d. What is the stock price using the dividend discount model?

e. What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 60 percent (holding all else constant)? What would happen to the P/E ratio (P/E1) and stock price if the company paid out all its earnings in the form of dividends?

f. What have you learned about the relationship between the retention rate and the P/E ratio?