ART has come out with a new and improved product. As a result, the firm projects an ROE of 25%, and it will maintain a plowback ratio of 0.20. Its earnings this year will be $3 per share. Investors expect a 12% rate of return on the shares. At what price would you expect ART to sell?

Question

Quizplus · Accepted Answer

We can use the Gordon growth model to solve for the expected price of ART's shares:

Price = (Dividend*(1+g))/r-g
where
Dividend = 0.80*Earnings = 0.80*$3 = $2.40 (plowback ratio of 0.20 means that 80% of earnings will be paid out as dividends)
r = 12%
g = ROE*plowback ratio = 25%*0.20 = 5%

Substituting the values, we get:
Price = ($2.40*(1+0.05))/0.12-0.05 = $34.29

Therefore, the expected price of ART's shares is $34.29. Option B is the correct choice.

ART Has Come Out with a New and Improved Product