(Common stock valuation) Assume the following:

- The investors required rate of return is 15 percent

-the expected level of earnings at the end of this year is (E1) is $10

- the retention ratio is 35 percent

-the return on equity is 13 percent (that is, it can earn 13 percent on reinvested earnings)

-similar shares of stock sell at multiples of 6.220 times earnings per share

Questions:

a) Determine the expected growth rate for dividends

b) Determine the price earnings ratio (P/E1)

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? What would happen to the P/E ratio 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?