Question

Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $957,000. Without new projects, both firms will continue to generate earnings of $957,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 14 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.) PE ratio 7.14 times b. Pacific Energy Company has a new project that will generate additional earnings of $107,000 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.) PE ratio times c. U.S. Bluechips has a new project that will increase earnings by $207,000 in perpetuity. Calculate the new PE ratio of the firm.

Answer 1

a	P/E Ratio =	Price / Earnings
	We will use zero growth model to calculate the value of stock today.
	Price =	Dividend / required rate of return
	Price =	$957000/.14
		$6835714.29
	P/E ratio is calculated :
	P/E =	$6835714.29/$957000
	PE	7.14 times
b	Pacific energy company will have additional earnings of $107000 and all the earnings will
	be distributed as dividend.
	Total dividend paid by Pacific energy will be =	$957000+ $107000
		$1064000
	Value of pacific energy with dividend paid $1064000
	Price =	$1064000/.14
		$7600000
	PE ratio =	$7600000/$1064000
		7.14 times
c	U.S Bluechips will have additional earnings of $207000 and all the earnings will
	be distributed as dividend.
	Total dividend paid by Pacific energy will be =	$957000+ $207000
		$1164000
	Value of pacific energy with dividend paid $1164000
	Price =	$1164000/.14
		$8314285.71
	PE ratio =	$8314285.71/$1164000
		7.14 times
	Note: when all the earnings are distributed as dividend , The PE ratio remains
	constant

Answer 2

SOLUTION :

a.

Current value of stocks of both companies 

= PV of future cash flows of $957000 in perpetuity discounted at 14%.

= 957000 / 0.14

= 6835714.29 ($)

Let number of shares be N.

So, 

Price per share = 6835714.29 / N  ($)

Earring per share = 957000 / N   ($)

PE ratio of each company.

= (6835714.29 / N) / (957000 / N) 

= 6835714.29 / 957000 

= 7.14 (ANSWER). 

b. 

With new project, earnings of Pacific energy company 

= 957000 + 107000 = 1064000 

PE ratio of this company 

= Value of company / Earnings

= (1064000 / 0.14) / 1064000 

= 7.14  (ANSWER) 

c.

With new project, earnings of US bluechip company 

= 957000 + 207000 = 1164000 

PE ratio of this company 

= Value of company / Earnings

= (1164000 / 0.14) / 1164000 

= 7.14  (ANSWER)