Question

Even Better Products has come out with a new and improved product. As a result, the firm projects an ROE of 20%, and it will maintain a plowback ratio of 0.40. Its projected earnings are $3 per share. Investors expect a 14% rate of return on the stock. a. At what price and P/E ratio would you expect the firm to sell? (Do not round intermediate calculations. Round your answers to 2 decimal places.) Price P/E ratio b. What is the present value of growth opportunities? (Do not round intermediate calculations. Round your answer to 2 decimal places.) PVGO $ 8.62 c. What would be the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 30% of its earnings? (Do not round intermediate calculations. Round your answers to 2 decimal places.) P/E ratio PVGO

Answer 1

Given about Even Better Products,

ROE = 20%

Plowback ratio b = 0.4 or 40%

expected earning E1 = $3

expected return on stock r = 14%

So, growth rate of the firm g = ROE*b = 0.2*0.4 = 0.08 or 8%

a). So, expected price using constant dividend growth model is

price P0 = E1*(1-b)/(r-g) = 3*(1-0.4)/(0.14-0.08) = $30

P/E ratio = P0/E1 = 30/3 = 10

b). Present value of growth opportunity PVGO = P0 - E1/r = 30 - 3/0.14 = $8.57

c). When reinvestment rate/plowback ratio b = 0.3 or 30%

So, new growth rate = ROE*b = 0.2*0.3 = 0.06 or 6%

So. New P/E ratio = (1-b)/(r-g) = (1-0.3)/(0.14-0.06) = 8.75 times

New PVGO = (P/E)*E - E/r = 8.75*3 - 3/0.14 = $4.82