(Common stock valuation) Assume the following:

• the investor's required rate of return is 13 percent
• the expected level of earnings at the end of this year (E1) is $12
• the retention ratio is 50 percent
• the reutn on equity (ROE) is 13 percent (that is, it can earn 13 percent on reinvested earnings)
• similar shares of stock sell at multiples of 7.693 times earnings per share

Questions:

• What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 75 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?
• What have you learned about the relationship between the retention rate and the P/E ratios?