USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Assume that the dividend payout ratio will be 75 percent when the rate on long-term government bonds falls to 8 percent. Because investors are becoming more risk averse, the equity risk premium will rise to 7 percent and investors will require a 15 percent return. The return on equity will be 12 percent.
-Refer to Exhibit 9.2. What is your expectation of the market P/E ratio?
A) 3.92
B) 6.25
C) 6.67
D) 8.33
E) 12.00

Question

Quizplus · Accepted Answer

The market P/E ratio can be calculated using the Gordon Growth Model formula: P/E = (D1/E1) / (k - g), where D1/E1 is the dividend payout ratio, k is the required return on equity, and g is the growth rate of dividends (which can be found by reinvesting the retained earnings, calculated as 1 - dividend payout ratio, at the return on equity). Given a dividend payout ratio of 75%, the required return of 15%, and a return on equity of 12%, we first find the growth rate: g = (1 - 0.75) * 12% = 0.25 * 12% = 3%. Plugging these values into the formula gives us P/E = 0.75 / (0.15 - 0.03) = 0.75 / 0.12 = 6.25.