Question

Alpha Corp. has a market capitalization rate of 12%, an ROE of 16% and a plowback ratio of 50%.

5. What is Alpha Corp's expected earnings growth rate?

a) 6% b) 8% c)12% d)4%

6. Alpha Corp's P/E ratio is closest to:

a)2 b)6.25 c)8.3 d)12.5

7. Suppose Alpha Corp. decides to pay out 100% of its earnings. What will happen to its P/E ratio?

a)The P/E ratio will decrease.

b)The P/E ratio will increase.

c)The P/E ratio will remain constant.

Use the following information to answer questions 8, 9 and 10. Beta Corp. has a market capitalization rate of 12%, an ROE of 10% and a plowback ratio of 80%.

8. What is Beta Corp's expected earnings growth rate?

a)8% b)6% c)4% d)12%

9. Beta Corp's P/E ratio is closest to:

a)1.25 b)8.3 c)5 d)2.5

10.Suppose Beta. Corp decides to pay out 100% of its earnings. What will happen to its P/E ratio?

a)The P/E ratio will decrease.

b)The P/E ratio will increase.

c)The P/E ratio will remain constant.

Answer 1

5 ) Earning growth rate is = ROE * Plowback Ratio = 16 % * 50% = 8%

6) P./ E Ratio = 1- b / k - ROE * b { Where in b is the plowback ratio and K is the market capitalization rate.) = 1- 05 / 12% - 16% * 0.5 = 8.33 or 8.3.

7) Now if Alpha Corp decides to payout 100 % of the earnings then b or the plowback ratio becomes 0% therefore the P/E ratio would be 1 - b / K - ROE *b = 1 - 0 / 12% -16% * 0 = 8.33

Thefore it can be said that if all earnings are paidout then the P/E ratio will remain constant.

8) Beta Corp's earnings growth rate = ROE * plowback ratio = 10% * 80 % = 8 % .

9) Beta's P/E ratio = 1 - b / k - ROE . b { where is b is the plowback ratio and k is the market Capitalization rate } = 1- 0.8 / 0.12 - 0.10 * 0.8 = 0.2 / 0.12 - 0.08 = 5

10) Lastly, if Beta pays out 100% of its earnings P/ E ratio would be 1- 0 / 0.12 - 0.10 * 0 = 8.33 , here the price earnings will be rising or going up this is because the stocks are a higher value in the market compared to the ROE.