Iii equity risk premium would cause pe ratios to be

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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
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