(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

$8,

the retention ratio is

40

percent,

the return on equity

(ROE)

is

12

percent (that is, it can earn

12

percent on reinvested earnings), and

similar shares of stock sell at multiples of

7.318

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

65

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?