luation) 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 $14, • the retention ratio is 45
luation) 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 $14, • the retention ratio is 45
Chapter8: Analysis Of Risk And Return
Section: Chapter Questions
Problem 11P
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Concept explainers
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Question
Common stock valuation) Assume the following:
•
the investor's required 12.5
percent,•
the expected level of earnings at the end of this year
(E1)
is
$14,
•
the retention ratio is
45
percent,•
the (ROE)
is
15
percent (that is, it can earn
15
percent on reinvested earnings), and•
similar shares of stock sell at multiples of
9.565
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
60
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?
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