Consider a firm that is expected to earn $5 per share next year. EPS will continue at this level

in perpetuity without any additional investment. Investors require a 10% rate of return.

a. What is the price per share and P/E ratio?

b. A new investment opportunity arises allowing the firm to plow back exactly $3 per share

at the end of each of the next five years and nothing thereafter. Each investment is

expected to earn a level annual return of 25% in perpetuity, starting the year after the

investment is made. What is the new price per share and P/e ratio?

c. Suppose the expected reinvestment rate were only 10% in part (b). What would be the

new stock price? Show that the P/E ratio is the reciprocal of the interest rate in this case.