Question

Consider Pacific Energy Company and Atlantic Energy, Inc., both of which reported earnings of $969,000. Without new projects, both firms will continue to generate earnings of $969,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 12 percent.

  

a.	What is the current PE ratio for each company? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

b.	Pacific Energy Company has a new project that will generate additional earnings of $119,000 each year in perpetuity. Calculate the new PE ratio of the company. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

c.	Atlantic Energy has a new project that will increase earnings by $219,000 in perpetuity. Calculate the new PE ratio of the firm. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Given,

Earnings = $969000

Rate of return (r) = 12% or 0.12

Solution :-

(a)

Price = earnings r

= $969000 0.12 = $8075000

P/E ratio = Price Earnings

= $8075000 $969000 = 8.33

(b)

Additional earnings = $119000

New earnings = earnings + additional earnings

= $969000 + $119000 = $1088000

New price = New earnings r

= $1088000 0.12 = $9066666.66667

New P/E ratio = New price earnings

= $9066666.66667 $969000 = 9.36

(c)

Additional earnings = $219000

New earnings = $969000 + $219000 = $1188000

New price = New earnings r

= $1188000 0.12 = $9900000

New P/E ratio = New price earnings

= $9900000 $969000 = 10.22