Assume the following:

the investor's required rate of return is 14.5 percent,

the expected level of earnings at the end of this year (E1) is $14,

the retention ratio is 50 percent,

the return on equity (ROE) is 15 percent (that is, it can earn 15 percent on reinvested earnings), and

similar shares of stock sell at multiples of 7.143 times earnings per share.

a.What is the expected growth rate for dividends?

7.57.5%

b.What is the price earnings ratio (P/E1)?

7.145

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

$100

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

$100

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e.What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 80 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 ratios?