Common stock valuation)Assume the following:

the investor's required rate of return is

12.5

percent,

the expected level of earnings at the end of this year

(E1)

is

$12,

the retention ratio is

45

percent,

the return on equity

(ROE)

is

14

percent (that is, it can earn

14

percent on reinvested earnings), and

similar shares of stock sell at multiples of

8.871

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

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?

Question content area bottom

Part 1

a.What is the expected growth rate for dividends?

enter your response here%

(Round to two decimal places.)

Part 2

b.What is the price earnings ratio

(P/E1)?

enter your response here

(Round to three decimal places.)

Part 3

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

$enter your response here

(Round to the nearest cent.)

Part 4

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

$enter your response here

(Round to the nearest cent.)

Part 5

e. (i)Using the dividend discount model, what would be the stock price if the company increased its retention rate to

80%

(holding all else constant)?

$enter your response here

(Round to the nearest cent.)

Part 6

What would be the P/E ratio

(P/E1)

if the company increased its retention ratio to

80%

(holding all else constant)?

enter your response here

(Round to three decimal places.)

Part 7

e. (ii)Using the dividend discount model, what would be stock price if the company paid out all its earnings in the form of dividends?

$enter your response here

(Round to the nearest cent.)

Part 8

What would be the P/E ratio

(P/E1)

and stock price if the company paid out all its earnings in the form of dividends?

enter your response here

(Round to three decimal places.)

Part 9

f.What have you learned about the relationship between the retention ratio and the P/E ratio?(Select from the drop-down menus.)

Assume that the investor's required rate of return is greater than the dividend growth rate, the higher the retention ratio, other things being the same, the

lower

higher

the value of the common stock and thus the

lower

higher

the price earnings ratio,

P/E.