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Retention ratio net income dividend per share shares

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Retention ratio = [Net Income – (Dividend per share × shares outstanding)]/Net Income Retention ratio increased from 0.6154 in 2000 to 0.7091 in 2003. This increase in the retention ratio directly increased the sustainable growth rate because the retention ratio is one of the two factors determining the sustainable growth rate. ii. The decrease in leverage reduced the sustainable growth rate. Financial leverage = (Total Assets/Beginning of year equity) Financial leverage decreased from 2.34 (= 3230/1380) at the beginning of 2000 to 2.10 at the beginning of 2003 (= 3856/1836) This decrease in leverage directly decreased ROE (and thus the sustainable growth rate) because financial leverage is one of the factors determining ROE (and ROE is one of the two factors determining the sustainable growth rate). 18-6
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13. a. The formula for the Gordon model is: V 0 = [D 0 × (1 + g)]/(r – g) where: D 0 = dividend paid at time of valuation g = annual growth rate of dividends r = required rate of return for equity In the above formula, P 0 , the market price of the common stock, substitutes for V 0 and g becomes the dividend growth rate implied by the market: P 0 = [D 0 × (1 + g)]/(r – g) Substituting, we have: 58.49 = [0.80 × (1 + g)]/(0.08 – g) g = 6.54% b. Use of the Gordon growth model would be inappropriate to value Dynamic’s common stock, for the following reasons: i. The Gordon growth model assumes a set of relationships about the growth rate for dividends, earnings, and stock values. Specifically, the model assumes that dividends, earnings, and stock values will grow at the same constant rate. In valuing Dynamic’s common stock, the Gordon growth model is inappropriate because management’s dividend policy has held dividends constant in dollar amount although earnings have grown, thus reducing the payout ratio. This policy is inconsistent with the Gordon model assumption that the payout ratio is constant. ii. It could also be argued that use of the Gordon model, given Dynamic’s current dividend policy, violates one of the general conditions for suitability of the model, namely that the company’s dividend policy bears an understandable and consistent relationship with the company’s profitability. 14. a. The industry’s estimated P/E can be computed using the following model: P 0 /E 1 = payout ratio/(r g) However, since r and g are not explicitly given, they must be computed using the following formulas: g ind = ROE × retention rate = 0.25 × 0.40 = 0.10 r ind = government bond yield + ( industry beta × equity risk premium) = 0.06 + (1.2 × 0.05) = 0.12 Therefore: P 0 /E 1 = 0.60/(0.12 0.10) = 30.0 18-7
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b. i. Forecast growth in real GDP would cause P/E ratios to be generally higher for Country A. Higher expected growth in GDP implies higher earnings growth and a higher P/E. ii. Government bond yield would cause P/E ratios to be generally higher for Country B. A lower government bond yield implies a lower risk-free rate and therefore a higher P/E.
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