(Common stock valuation) Assume the following:

the investor's required rate of return is 14.5%

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

the retention ratio is 35%

the return on equity (ROE) is 14% (that is, it can earn 14% on reinvested earnings)

similar shares of stock sell at multiples of 6.771 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 75% (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?