Question

Castles in the Sand generates a rate of return of 12% on its investments and maintains a plowback ratio of .40. Its earnings this year will be $3 per share. Investors expect a 10% rate of return on the stock. a) Find the price and P/E ratio of the firm. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Price $ P/E ratio b) Find the price and P/E ratio of the firm of the plowback ratio is reduced to .30. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Price $ P/E ratio

Answer 1

Answer:

(a) $34.61; 11.54

(b) $32.81; 10.94

Explanation:

(a) Stock Price = D ÷ (Ke – G)

Where,

D is dividend next year,

Ke is required rate of return on equity

G is growth rate

Growth rate = ROE × plow-back ratio

                    = 0.12 × 0.40

                    = 0.048 or 4.8%

Dividend = Current EPS × (1 - plow back ratio)

               = $3 × 0.6

               = $1.8

Stock Price:

= $1.8 ÷ (0.10 - 0.048)

= $34.61

P/E Ratio = Stock Price ÷ EPS

               = $34.61 ÷ $3

               = 11.54

(b) New growth rate = 0.12 × 0.30

                                  = 0.036 or 3.6%

Dividend = Current EPS × (1 - plow back ratio)

               = $3 × 0.7

               = $2.1

Stock Price = $2.1 ÷ (0.10 - 0.036)

                   = $32.81

P/E Ratio = Stock Price ÷ EPS

               = $32.81 ÷ $3

               = 10.94