Question
In: Finance
Assuming all the following firms have a required return of 9 percent, which would you expect...
Assuming all the following firms have a required return of 9 percent, which would you expect to have a positive present value of growth opportunities?
A) A firm with a P/E ratio of 8
B) A firm with a P/E ratio of 13
C) A firm with an E/P ratio of .10
D) A firm with an E/P ratio of .20
E) None of the answers are correct
Solutions
Expert Solution
| Solution: | ||||||
| Required Rate of Return : 9% | ||||||
| We know that Cost of Equity : 1/PE ratio | ||||||
| Calculation of Cost of Equity : | ||||||
| - A firm with P/E ratio : 8, hence Cost of Equity : | 1/ 8 = | 0.13 | or 13% | |||
| - A firm with P/E ratio : 13, hence Cost of Equity : | 1/13 = | 0.08 | or 8% | |||
| - A firm with E/P ratio : 0.10, hence Cost of Equity : | 0.10 | or 10% | ||||
| - A firm with E/P ratio : 0.20, hence Cost of Equity : | 0.20 | or 20% | ||||
| We know that , for a growing firm it is necessary to have its required rate of return | ||||||
| higher that its cost of equity. | ||||||
| In all the provided options firm with the P/E Ratio 13 will have Cost of Equity = 8% | ||||||
| and it is less than the Reuired Rate of return of 9%, in compare to other options | ||||||
| Hence, Option B is correct | ||||||
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