bkmsol_ch18

Iii equity risk premium would cause pe ratios to be

• Notes
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iii. Equity risk premium would cause P/E ratios to be generally higher for Country B. A lower equity risk premium implies a lower required return and a higher P/E. 15. a. k = D 1 /P 0 + g D 1 = 0.5 × \$2 = \$1 g = b × ROE = 0.5 × 0.20 = 0.10 Therefore: k = (\$1/\$10) + 0.10 = 0.20 = 20% b. Since k = ROE, the NPV of future investment opportunities is zero: 0 10 \$ 10 \$ k E P PVGO 1 0 = = = c. Since k = ROE, the stock price would be unaffected by cutting the dividend and investing the additional earnings. 16. a. g = ROE × b = 20% × 0.5 = 10% 11 \$ 10 . 0 15 . 0 10 . 1 50 . 0 \$ g k ) g 1 ( D g k D P 0 1 0 = × = + = = b. Time EPS Dividend Comment 0 \$1.0000 \$0.5000 1 \$1.1000 \$0.5500 g = 10%, plowback = 0.50 2 \$1.2100 \$0.7260 EPS has grown by 10% based on last year’s earnings plowback and ROE; this year’s earnings plowback ratio now falls to 0.40 and payout ratio = 0.60 3 \$1.2826 \$0.7696 EPS grows by (0.4) (15%) = 6% and payout ratio = 0.60 At time 2: 551 . 8 \$ 06 . 0 15 . 0 7696 . 0 \$ g k D P 3 2 = = = At time 0: 493 . 7 \$ ) 15 . 1 ( 551 . 8 \$ 726 . 0 \$ 15 . 1 55 . 0 \$ V 2 0 = + + = 18-8

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c. P 0 = \$11 and P 1 = P 0 (1 + g) = \$12.10 (Because the market is unaware of the changed competitive situation, it believes the stock price should grow at 10% per year.) P 2 = \$8.551 after the market becomes aware of the changed competitive situation. P 3 = \$8.551 × 1.06 = \$9.064 (The new growth rate is 6%.) Year Return 1 % 0 . 15 150 . 0 11 \$ 55 . 0 \$ ) 11 \$ 10 . 12 (\$ = = + 2 % 3 . 23 233 . 0 10 . 12 \$ 726 . 0 \$ ) 10 . 12 \$ 551 . 8 (\$ = = + 3 % 0 . 15 150 . 0 551 . 8 \$ 7696 . 0 \$ ) 551 . 8 \$ 064 . 9 (\$ = = + Moral: In "normal periods" when there is no special information, the stock return = k = 15%. When special information arrives, all the abnormal return accrues in that period , as one would expect in an efficient market. 17. a. k = r f + β [E(r M ) – r f ] = 8% + 1.2(15% – 8%) = 16.4% g = b × ROE = 0.6 × 20% = 12% 82 . 101 \$ 12 . 0 164 . 0 12 . 1 4 \$ g k ) g 1 ( D V 0 0 = × = + = b. P 1 = V 1 = V 0 (1 + g) = \$101.82 × 1.12 = \$114.04 % 52 . 18 1852 . 0 100 \$ 100 \$ 04 . 114 \$ 48 . 4 \$ P P P D ) r ( E 0 0 1 1 = = + = + = 18-9