Castles in the Sand generates a rate of return of 15% on its investments and mai

Question

Castles in the Sand generates a rate of return of 15% on its investments and maintains a plowback ratio of .50. Its earnings this year will be $6 per share. Investors expect a 12% rate of return on the stock. a. Find the price and P/E ratio of the firm. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Price P/E ratio b. Find the price and P/E ratio of the firm if the plowback ratio is reduced to 40. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Price P/E ratio

Explanation / Answer

A: As Per Walter Model :

PRICE= [EPS(1- P/B Ratio) / Ke ]+ [((r/Ke)(EPS* P/B Ratio)) / Ke)

= [6(1-.50) / .12] + [ ((.15/.12)(6*.50)) / .12]

= 3 /.12 + (1.25*3) /.12

=25 + 31.25 = 56.25 $

AND P/E Ratio = 56.25/6 = 9.375 Times

B)

Now if P/B Ratio reduce to 40%

then by applying above formulae

Price =(1.80 / .12) + ( 1.25*1.20 / .12)

=15+12.50 = 27.50 $

or P/E Ratio = 27.50 / 6 =4.58 Times

Note : Since Company rate of return is more then Investor expectation thats why when the retention of earning become less its price falls.

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