Question

EXERCISE #1: The market consensus is that Analog Electronic Corporation has an ROE = 10% and a beta of 1.2. It plans to maintain indefinitely its traditional plowback ratio of 2/3. This year's earnings were $3 per share. The annual dividend was just paid. The consensus estimate of the coming year's market return is 14%, and T-bills currently offer a 6% return

A. Use the CAPM to get the cost of equity: rE =
B. Using the plowback info, the current dividend: D0 =
C. The growth rate of dividends is: g =
D. Next year’s dividend is D1 =
E. The price of the stock is: P0 =
F. The current P0/E0 ratio is ............... and the forward P0/E1 ratio is ..................... G.ThePVGOisP0 –E1 /rE =

Answer 1

Cost of equity = Risk free rate + Beta * (Market return - Risk free rate)

Cost of equity = 6% + 1.2 * (14% - 6%)

Cost of equity = 15.6%

Current Dividend (D0) = Current Earnings * (1 - Plowback ratio)

Current Dividend (D0) = $3 * (1 - (2 / 3))

Current Dividend (D0) = $1

growth rate = Plowback ratio * ROE

growth rate = (2/3) * 10%

growth rate of dividends = 6.67%

Next year’s dividend = Current Dividend * (1 + growth rate of dividends)

Next year’s dividend = $1 * (1 + 6.67%)

Next year’s dividend = $1.0667

Price of Stock (P0) = Current Dividend * (1 + growth rate of dividends) / (Cost of Equity - growth rate of dividends)

Price of Stock (P0) = $1 * (1 + 6.67%) / (15.6% - 6.67%)

Price of Stock (P0) = $11.95

P0/E0 ratio = (1 - Plowback Ratio) * (1 + growth rate of dividends) / (Cost of Equity - growth rate of dividends)

P0/E0 ratio = (1 - (2/3) * (1 + 6.67%) / (15.6% - 6.67%)

P0/E0 ratio = 3.98

P0/E1 ratio = (1 - Plowback Ratio) / (Cost of Equity - growth rate of dividends)

P0/E1 ratio = (1 - (2/3)) / (15.6% - 6.67%)

P0/E1 ratio = 3.73

PVGO = P0 - (Earnings * (1 + growth rate) / Cost of Equity)

PVGO = $11.95 - ($3 * (1 + 6.67%) / 15.6%)

PVGO = -$8.56