USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Assume that the dividend payout ratio will be 55 percent when the rate on long-term government bonds falls to 9 percent. Because investors are becoming more risk averse, the equity risk premium will rise to 8 percent and investors will require a 7 percent return. The return on equity will be 13 percent.
-Refer to Exhibit 9.3. To what price will the market rise if the earnings expectation is $1.5?
A) $138.42
B) $90.36
C) $71.74
D) $105.30
E) $85.14

Question

Quizplus · Accepted Answer

Using the Dividend Discount Model:

Price = (Dividend/Earnings)*(1 - payout ratio)/(Required return - growth rate)

Given, 
Dividend = (1 - Payout ratio)* Earnings 
Payout ratio = 55%
Required return = risk-free rate + equity risk premium = 9% + 8% = 17%
Earnings = $1.5

Therefore, 
Dividend = (1-0.55)*$1.5 = $0.675 
Growth rate = (1 - payout ratio)*return on equity = (1 - 0.55)*13% = 5.85%

Price = ($0.675/$1.5)*(1-0.55)/(0.17-0.0585) = $71.74

Hence, the market will rise to $71.74 if the earnings expectation is $1.5.