USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The aggregate market currently has a retention ratio of 60 percent, a required rate of return of 12 percent, and an expected growth rate for dividends of 4 percent.
-Refer to Exhibit 9.9. Starting with the initial conditions, you expect the retention ratio to be constant, the rate of inflation to decline by 2 percent, and the growth rate to decline by 1 percent. What is the expected P/E?
A) 8.57
B) 8.00
C) 6.67
D) 5.71
E) 5.00

Question

Quizplus · Accepted Answer

To calculate the expected P/E, we can use the Gordon Growth Model: 
P/E = (Dividend payout ratio / Required return - Expected growth rate) 
Given the initial conditions: 
Dividend payout ratio = 1 - retention ratio = 0.4 
Required rate of return = 12% 
Expected growth rate for dividends = 4% 
Using these values, we can calculate the initial P/E as follows: 
P/E = (0.4 / 0.12 - 0.04) = 4.33

Next, we can calculate the expected P/E with the given changes: 
Retention ratio remains constant at 60%, so dividend payout ratio is still 0.4 
Required rate of return remains at 12% 
Expected growth rate for dividends declines by 1%, so it is now 3% 
Using these values, we can calculate the expected P/E as follows: 
P/E = (0.4 / 0.12 - 0.03) = 5.71

Therefore, the expected P/E is D) 5.71.