CHAPTER12:EQUITYVALUATION

1. P=2.10/0.11=19.09

2. (a)and(b).

3. a. Thisdirectorisconfused.Inthecontextoftheconstantgrowthmodel,itistrue
thatpriceishigherwhendividendsarehigherholdingeverythingelse
(includingdividendgrowth)constant.Buteverythingelsewillnotbeconstant.
Ifthefirmraisesthedividendpayoutrate,thenthegrowthrate(g)willfall,and
stockpricewillnotnecessarilyrise.Infact,ifROE>k,pricewillfall.

b. i.Anincreaseindividendpayoutreducesthesustainablegrowthrateasless
fundsarereinvestedinthefirm.
ii.Thesustainablegrowthrateis(ROEplowback),whichfallsasthe
plowbackratiofalls.Theincreaseddividendpayoutratereducesthegrowth
rateofbookvalueforthesamereasonlessfundsarereinvestedinthefirm.

4. a. g=ROEb=0.160.5=0.08=8.0%
D1=SFr2(1b)=SFr2(10.50)=SFr1.00
D1 SFr1.00
P0 SFr25.00
k g 0.12 0.08

b. P3=P0(1+g)3=SFr25(1.08)3=SFr31.49

D1
5. a. P0
kg
200 200
5,000 g 0.16 0.12 12%
0.16 g 5,000

D1 200
b. P0 1,818.18
k g 0.16 0.05
Thepricefallsinresponsetothemorepessimisticforecastofdividendgrowth.
Theforecastforcurrentearnings,however,isunchanged.Therefore,theP/E
ratiodecreases.ThelowerP/Eratioisevidenceofthediminishedoptimism
concerningthefirm'sgrowthprospects.

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6. a. False.Higherbetameansthattheriskofthefirmishigherandthediscount
rateappliedtovaluecashflowsishigher.Foranyexpectedpathofearnings
andcashflows,thepresentvalueofthecashflows,andtherefore,thepriceof
thefirmwillbelowerwhenriskishigher.Thustheratioofpricetoearnings
willbelower.

b. True.HigherROEmeansmorevaluablegrowthopportunities.

c. Uncertain.Theanswerdependsonacomparisonoftheexpectedrateof
returnonreinvestedearningswiththemarketcapitalizationrate.Ifthe
expectedrateofreturnonthefirm'sprojectsishigherthanthemarket
capitalizationrate,thenP/Ewillincreaseastheplowbackratioincreases.

7. a. g=ROEb=0.200.30=0.06=6.0%
D1=$2(1b)=$2(10.30)=$1.40
D1 $1.40
P0 $23.33
k g 0.12 0.06
P/E=$23.33/$2=11.67

E0 $2.00
b. PVGO=P0 =$23.33 $6.66
k 0.12

c. g=ROEb=0.200.20==0.04=4.0%
D1=$2(1b)=$2(10.20)=$1.60
D1 $1.60
P0 $20.00
k g 0.12 0.04
P/E=$20/$2=10.0
E0 $2.00
PVGO=P0 =$20.00 =$3.33
k 0.12

8. a. k=rf+(kMrf)=6%+1.25(14%6%)=16%
g=(2/3)9%=6%
D1=E0(1+g)(1b)=$31.06(1/3)=$1.06
D1 $1.06
P0 $10.60
k g 0.16 0.06

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 b. LeadingP0/E1=$10.60/$3.18=3.33
TrailingP0/E0=$10.60/$3.00=3.53

E0 $3
c. PVGO=P0 =$10.60 $8.15
k 0.16
ThelowP/EratiosandnegativePVGOareduetoapoorROE(9%)thatis
lessthanthemarketcapitalizationrate(16%).

d. Now,yourevisethefollowing:
b=1/3
g=1/30.09=0.03=3.0%
D1=E01.03(2/3)=$2.06
D1 $2.06
V0 $15.85
k g 0.16 0.03
V0increasesbecausethefirmpaysoutmoreearningsinsteadofreinvesting
earningsatapoorROE.Thisinformationisnotyetknowntotherestof
themarket.

9.ChineseTourCorporation
D1 RMB8.00
a. P0 RMB160.00
k g 0.10 0.05

b. Thedividendpayoutratiois8/12=2/3,sotheplowbackratioisb=(1/3).The
impliedvalueofROEonfutureinvestmentsisfoundbysolvingasfollows:
g=bROE
0.05=(1/3)ROEROE=15%

c. AssumingROE=k,thepriceis(E1/k)P0=RMB12/0.10=RMB120
Therefore,themarketispaying(RMB160RMB120)=RMB40pershare
forgrowthopportunities.

10. HighFlyerstock
k=rf+(kMrf)=10%+1.5(15%10%)=17.5%
Therefore:
D1 2.50
P0 20.00
k g 0.175 0.05

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11. ThreedifferentvaluationapproachesforAmericanTobacco:
a. Assetvalueapproach:Alloftheassetrelatedpersharemeasuresfallbelow
therecentmarketprice,andthereforethestockisnotattractiveonthisbasis:
Recentprice $54.00
Bookvaluepershare 12.10
Liquidationvaluepershare 9.10
Replacementcostsofassetspershare 19.50

b. ConstantgrowthDDMapproach:V0=Dl/(kg)=$2.10/(0.130.10)=$70
Thusintrinsicvalueexceedsmarketprice,sothestockisattractiveonthisbasis.

c. Earningsmultiplierapproach:IfweapplytheP/EmultiplieroftheS&P500to
AmericanTobaccosestimatedEPS,weget:23.2$4.80=$111.36
ThisexceedsAmericanTobaccosmarketprice.(Equivalently,American
TobaccosP/Eratioisonly11.3,whichisconsiderablylessthanthatofthe
market.)IfyoubelievethatthereisnoreasonforsuchalargedisparityinP/E
multiples,youmightconcludethatthestockisunderpricedbythemarket.

12. a. ItistruethatNewSoftsellsathighermultiplesofearningsandbookvalue
thanCapital.ButthisdifferencemaybejustifiedbyNewSoftshigher
expectedgrowthrateofearningsanddividends.NewSoftisinagrowing
marketwithabundantprofitandgrowthopportunities.Capitalisinamature
industrywithfewergrowthprospects.Boththepriceearningsandpricebook
ratiosreflecttheprospectofgrowthopportunities,indicatingthattheratiosfor
thesefirmsdonotnecessarilyimplymispricing.

b. Themostimportantweaknessoftheconstantgrowthdividenddiscountmodelin
thisapplicationisthatitassumesaperpetualconstantgrowthrateofdividends.
WhiledividendsmaybeonasteadygrowthpathforCapital,whichisamore
maturefirm,thatisfarlesslikelytobearealisticassumptionforNewSoft.

c. NewSoftshouldbevaluedusingamultistageDDM,whichallowsforrapid
growthintheearlyyears,butalsorecognizesthatgrowthmustultimately
slowtoamoresustainablerate.

13.
StockA StockB
a. Dividendpayoutratio=1b $1/$2=0.50 $1/$1.65=0.606
b. Growthrate=g=ROEb 0.140.5= 0.120.394=4.728%
7.0%
c. Intrinsicvalue=V0 $1/(0.100.07) $1/(0.100.04728)
=$33.33 =$18.97

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d. YouwouldchoosetoinvestinStockAsinceitsintrinsicvalueexceedsits
price.YoumightchoosetosellshortstockB.

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14. a. TheindustrysestimatedP/Ecanbecomputedusingthefollowingmodel:
P0/E1=payoutratio/(rg)
However,sincerandgarenotexplicitlygiven,theymustbecomputedusing
thefollowingformulas:
gind=ROEretentionrate=0.250.40=0.10
rind=governmentbondyield+(industrybetaequityriskpremium)
=0.06 + (1.2 0.05) = 0.12
Therefore:
P0/E1=0.60/(0.120.10)=30.0

b. i.ForecastgrowthinrealGDPwouldcauseP/Eratiostobegenerallyhigher
forCountryA.HigherexpectedgrowthinGDPimplieshigherearnings
growthandahigherP/E.
ii.GovernmentbondyieldwouldcauseP/Eratiostobegenerallyhigherfor
CountryB.Alowergovernmentbondyieldimpliesalowerriskfreerateand
thereforeahigherP/E.
iii.EquityriskpremiumwouldcauseP/Eratiostobegenerallyhigherfor
CountryB.Alowerequityriskpremiumimpliesalowerrequiredreturn
andahigherP/E.

15. a. k=rf+(rM)rf]=4.5%+1.15(14.5%4.5%)=16%

b. Year Dividends
1999 1.72
2000 1.721.12 =1.93
2001 1.721.122 =2.16
2002 1.721.123 =2.42
2003 1.721.1231.09 =2.63
Presentvalueofdividendspaidinyears2000to2002:
Year PVofDividends
2000 1.93/1.161=1.66
2001 2.16/1.162=1.61
2002 2.42/1.163=1.55
Total: 4.82
D 2003 2.63
P2002 37.57
k g 0.16 0.09
PV(in1999)ofP2002=37.57/(1.163)=24.07
Intrinsicvalueofstock=4.82+24.07=28.89

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 c. ThetablepresentedintheproblemindicatesthatQuickBrushisselling
belowintrinsicvalue,whilewehavejustshownthatSmileWhiteisselling
somewhatabovetheestimatedintrinsicvalue.Basedonthisanalysis,Quick
Brushoffersthepotentialforconsiderableabnormalreturns,whileSmile
Whiteoffersslightlybelowmarketriskadjustedreturns.

d. StrengthsoftwostageDDMcomparedtoconstantgrowthDDM:
Thetwostagemodelallowsforseparatevaluationoftwodistinctperiodsina
companysfuture.Thisapproachcanaccommodatelifecycleeffects.Italso
canavoidthedifficultiesposedwhentheinitialgrowthrateishigherthanthe
discountrate.
Thetwostagemodelallowsforaninitialperiodofabovesustainablegrowth.
Itallowstheanalysttomakeuseofherexpectationsastowhengrowthmay
shifttoamoresustainablelevel.
AweaknessofallDDMsisthattheyareallverysensitivetoinputvalues.
Smallchangesinkorgcanimplylargechangesinestimatedintrinsicvalue.
Theseinputsaredifficulttomeasure.

16. a. ThevalueofashareofRioNationalequityusingtheGordongrowthmodel
andthecapitalassetpricingmodelis$22.40,asshownbelow.
Calculatetherequiredrateofreturnusingthecapitalassetpricingmodel:
k=rf+(Kmrf)=4%+1.8(9%4%)=13%
CalculatethesharevalueusingtheGordongrowthmodel:
D o (1 g) $0.20 (1 0.12)
P0 $22.40
k g 0.13 0.12

b. ThesustainablegrowthrateofRioNationalis9.97%,calculatedasfollows:
g=bROE=EarningsRetentionRateROE=(1PayoutRatio)ROE=
Dividends Net Income $3.20 $30.16
1 1 0.0997 9.97%
Net Income Beginning Equity $30.16 $270.35

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17. a. Toobtainfreecashflowtoequity(FCFE),thetwoadjustmentsthatShaar
shouldmaketocashflowfromoperations(CFO)are:
1. Subtractinvestmentinfixedcapital:CFOdoesnottakeintoaccountthe
investingactivitiesinlongtermassets,particularlyplantandequipment.
Thecashflowscorrespondingtothosenecessaryexpendituresarenot
availabletoequityholdersandthereforeshouldbesubtractedfromCFOto
obtainFCFE.
2. Addnetborrowing:CFOdoesnottakeintoaccounttheamountofcapital
suppliedtothefirmbylenders(e.g.,bondholders).Thenewborrowings,
netofdebtrepayment,arecashflowsavailabletoequityholdersand
shouldbeaddedtoCFOtoobtainFCFE.

b. Note1:RioNationalhad$75millionincapitalexpendituresduringtheyear.
Adjustment:negative$75million
Thecashflowsrequiredforthosecapitalexpenditures($75million)areno
longeravailabletotheequityholdersandshouldbesubtractedfromnet
incometoobtainFCFE.
Note2:Apieceofequipmentthatwasoriginallypurchasedfor$10millionwas
soldfor$7millionatyearend,whenithadanetbookvalueof$3million.
EquipmentsalesareunusualforRioNational.
Adjustment:positive$3million
IncalculatingFCFE,onlycashflowinvestmentsinfixedcapitalshouldbe
considered.The$7millionsalepriceofequipmentisacashinflownow
availabletoequityholdersandshouldbeaddedtonetincome.However,the
gainoverbookvaluethatwasrealizedwhensellingtheequipment($4million)
isalreadyincludedinnetincome.Becausethetotalsaleiscash,notjustthe
gain,the$3millionnetbookvaluemustbeaddedtonetincome.Therefore,the
adjustmentcalculationis:
$7millionincashreceived$4millionofgainrecordedinnetincome=
$3millionadditionalcashreceivedthatmustbeaddedtonetincometo
obtainFCFE.
Note3:Thedecreaseinlongtermdebtrepresentsanunscheduledprincipal
repayment;therewasnonewborrowingduringtheyear.
Adjustment:negative$5million
Theunscheduleddebtrepaymentcashflow($5million)isanamountno
longeravailabletoequityholdersandshouldbesubtractedfromnetincome
todetermineFCFE.

128
 Note4:On1January2002,thecompanyreceivedcashfromissuing
400,000sharesofcommonequityatapriceof$25.00pershare.
Noadjustment
TransactionsbetweenthefirmanditsshareholdersdonotaffectFCFE.
TocalculateFCFE,therefore,noadjustmenttonetincomeisrequired
withrespecttotheissuanceofnewshares.
Note5:Anewappraisalduringtheyearincreasedtheestimatedmarket
valueoflandheldforinvestmentby$2million,whichwasnotrecognized
in2002income.
Noadjustment
Theincreasedmarketvalueofthelanddidnotgenerateanycashflowand
wasnotreflectedinnetincome.TocalculateFCFE,therefore,noadjustment
tonetincomeisrequired.

c. Freecashflowtoequity(FCFE)iscalculatedasfollows:
FCFE=NI+NCCFCINVWCINV+NetBorrowing
where NCC=noncashcharges
FCINV=investmentinfixedcapital
WCINV=investmentinworkingcapital
Million$ Explanation
NI= $30.16 FromExhibit16B
NCC= +$67.17 $71.17(depreciationandamortizationfromExhibit16B)
$4.00*(gainonsalefromNote2)
FCINV= $68.00 $75.00(capitalexpendituresfromNote1)
$7.00*(cashonsalefromNote2)
WCINV= $24.00 $3.00(increaseinaccountsreceivablefromExhibit16A+
$20.00(increaseininventoryfromExhibit16A)+
$1.00(decreaseinaccountspayablefromExhibit16A)
NetBorrowing= +($5.00) $5.00(decreaseinlongtermdebtfromExhibit16A)
FCFE= $0.33
*SupplementalNote2inExhibit16CaffectsbothNCCandFCINV.

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18. RioNationalsequityisrelativelyundervaluedcomparedtotheindustryonaP/E
togrowth(PEG)basis.RioNationalsPEGratioof1.33isbelowtheindustryPEG
ratioof1.66.ThelowerPEGratioisattractivebecauseitimpliesthatthegrowth
rateatRioNationalisavailableatarelativelylowerpricethanisthecaseforthe
industry.ThePEGratiosforRioNationalandtheindustryarecalculatedbelow:
RioNational
CurrentPrice=$25.00
NormalizedEarningsperShare=$1.71
PricetoEarningsRatio=$25/$1.71=14.62
GrowthRate(asapercentage)=11
PEGRatio=14.62/11=1.33
Industry
PricetoEarningsRatio=19.90
GrowthRate(asapercentage)=12
PEGRatio=19.90/12=1.66

19. NogroCorporation
a. D1=0.5200=100
g=bROE=0.50.20=0.10
Therefore:
D1 100
k= g 0.10 0.20 20.0%
P0 1,000

b. Sincek=ROE,theNPVoffutureinvestmentopportunitiesiszero:
E0
PVGO P0 1,0001,000=0
k

c. Sincek=ROE,thestockpricewouldbeunaffectedifNogroweretocutits
dividendpayoutratioto25%.Theadditionalearningsthatwouldbe
reinvestedwouldearntheROE(20%).
Again,ifNogroeliminatedthedividend,thiswouldhavenoimpactonNogros
stockpricesincetheNPVoftheadditionalinvestmentswouldbezero.

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20. XyrongCorporation
a. k=rf+[E(rM)rf]=8%+1.2(15%8%)=16.4%
g=bROE=0.60.20=12%
D 0 (1 g) 4won 1.12
V0 101.82won
k g 0.164 0.12

b. P1=V1=V0(1+g)=101.82won1.12=114.04won

D1 P1 P0 4.48 114 .04 100

E(r)= = 0.1852 18.52%
P0 100

21. a. ThesolutionisshownintheExcelspreadsheetbelow:
Inputs Year Dividen Div growth Term value Investor CF
d
beta 1.35 2005 0.32 0.32
mkt_prem 0.06 2006 0.41 0.41
rf 0.05 2007 0.50 0.50
k_equity 0.131 2008 0.60 0.60
plowback 0.75 2009 0.72 0.20 0.72
roe 0.14 2010 0.86 0.19 0.86
term_gwt 0.105 2011 1.01 0.18 1.01
h
2012 1.18 0.17 1.18
2013 1.37 0.16 1.37
2014 1.58 0.15 1.58
Value line 2015 1.80 0.14 1.80
forecasts of 2016 2.03 0.13 2.03
annual dividends 2017 2.28 0.12 2.28
2018 2.53 0.11 2.53
2019 2.78 0.10 2.78
Transitional period 2020 3.07 0.10500 130.55 133.62
with slowing dividend
growth 24.82 = PV of CF
Beginning of constant E17 * (1+ F17)/(B5 F17)
growth period NPV(B5,H2:H17)

b.,c. UsingtheExcelspreadsheet,wefindthattheintrinsicvaluesare$25.76and
$13.50,respectively.

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22. ThesolutionsderivedfromSpreadsheet12.2areasfollows:
Intrinsicvalue: Intrinsicvalue: Intrinsicvalue Intrinsicvalue
FCFF FCFE pershare:FCFF pershare:FCFE
a. 40,170 31,187 11.23 10.31
b. 47,087 36,507 13.52 12.07
c. 34,337 26,520 9.30 8.77

23. Usingatwostagedividenddiscountmodel,thecurrentvalueofashareof
Sundanciiscalculatedasfollows:
D3
D1 D2 (k g)
V0
(1 k ) (1 k )
1 2
(1 k ) 2
$0.5623
$0.3770 $0.4976 (0.14 0.13)
$43.98
1.141 1.14 2 1.14 2
where:
E0=$0.952
D0=$0.286
E1=E0(1.32)1=$0.9521.32=$1.2566
D1=E10.30=$1.25660.30=$0.3770
E2=E0(1.32)2=$0.952(1.32)2=$1.6588
D2=E20.30=$1.65880.30=$0.4976
E3=E0(1.32)21.13=$0.952(1.32)31.13=$1.8744
D3=E30.30=$1.87440.30=$0.5623

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24. a. Freecashflowtoequity(FCFE)isdefinedasthecashflowremainingafter
meetingallfinancialobligations(includingdebtpayment)andaftercovering
capitalexpenditureandworkingcapitalneeds.TheFCFEisameasureof
howmuchthefirmcanaffordtopayoutasdividends,butinagivenyearmay
bemoreorlessthantheamountactuallypaidout.
Sundanci'sFCFEfortheyear2000iscomputedasfollows:
FCFE =
Earnings after tax + Depreciation expense Capital expenditures Increase in NWC =
$80 million + $23 million $38 million $41 million = $24 million
FCFEpershare=FCFE/numberofsharesoutstanding=
$24million/84millionshares=$0.286
Atthegivendividendpayoutratio,Sundanci'sFCFEpershareequals
dividendspershare.

b. TheFCFEmodelrequiresforecastsofFCFEforthehighgrowthyears(2001
and2002)plusaforecastforthefirstyearofstablegrowth(2003)inorderto
allowforanestimateoftheterminalvaluein2002basedonperpetualgrowth.
BecauseallofthecomponentsofFCFEareexpectedtogrowatthesamerate,
thevaluescanbeobtainedbyprojectingtheFCFEatthecommonrate.
(Alternatively,thecomponentsofFCFEcanbeprojectedandaggregatedfor
eachyear.)
ThefollowingtableshowstheprocessforestimatingSundanci'scurrentvalue
onapersharebasis:

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Free Cash Flow to Equity
BaseAssumptions
Sharesoutstanding:84millions
Requiredreturnonequity(r):14%
Actual Projected Projected Projected
2000 2001 2002 2003
Growthrate(g) 27% 27% 13%
Total Pershare
Earningsaftertax $80 $0.952 $1.2090 $1.5355 $1.7351
Plus:Depreciationexpense $23 $0.274 $0.3480 $0.4419 $0.4994
Less:Capitalexpenditures $38 $0.452 $0.5740 $0.7290 $0.8238
Less:Increaseinnetworkingcapital $41 $0.488 $0.6198 $0.7871 $0.8894
Equals:FCFE $24 $0.286 $0.3632 $0.4613 $0.5213
Terminalvalue $52.1300*
Totalcashflowstoequity $0.3632 $52.5913**
Discountedvalue $0.3186*** $40.4673***
Currentvaluepershare $40.7859****
*Projected2002Terminalvalue=(Projected2003FCFE)/(rg)
**Projected2002Totalcashflowstoequity=
Projected2002FCFE+Projected2002Terminalvalue
***Discountedvaluesobtainedusingr=14%
****Currentvaluepershare=
SumofDiscountedProjected2001and2002Totalcashflowstoequity

c. i.Thefollowinglimitationsofthedividenddiscountmodel(DDM)are
addressedbytheFCFEmodel.TheDDMusesastrictdefinitionofcashflows
toequity,i.e.theexpecteddividendsonthecommonstock.Infact,takentoits
extreme,theDDMcannotbeusedtoestimatethevalueofastockthatpaysno
dividends.TheFCFEmodelexpandsthedefinitionofcashflowstoincludethe
balanceofresidualcashflowsafterallfinancialobligationsandinvestment
needshavebeenmet.ThustheFCFEmodelexplicitlyrecognizesthefirms
investmentandfinancingpoliciesaswellasitsdividendpolicy.Ininstancesof
achangeofcorporatecontrol,andthereforethepossibilityofchangingdividend
policy,theFCFEmodelprovidesabetterestimateofvalue.TheDDMisbiased
towardfindinglowPIEratiostockswithhighdividendyieldstobeundervalued
andconversely,highPIEratiostockswithlowdividendyieldstobeovervalued.
Itisconsideredaconservativemodelinthatittendstoidentifyfewer
undervaluedfirmsasmarketpricesriserelativetofundamentals.TheDDM
doesnotallowforthepotentialtaxdisadvantageofhighdividendsrelativeto

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 thecapitalgainsachievablefromretentionofearnings.
ii.ThefollowinglimitationsoftheDDMarenotaddressedbytheFCFE
model.Bothtwostagevaluationmodelsallowfortwodistinctphasesof
growth,aninitialfiniteperiodwherethegrowthrateisabnormal,followedby
astablegrowthperiodthatisexpectedtolastindefinitely..Thesetwostage
modelssharethesamelimitationswithrespecttothegrowthassumptions.
First,thereisthedifficultyofdefiningthedurationoftheextraordinary
growthperiod.Forexample,alongerperiodofhighgrowthwillleadtoa
highervaluation,andthereisthetemptationtoassumeanunrealisticallylong
periodofextraordinarygrowth.Second,theassumptionofasuddenshift
formhighgrowthtolower,stablegrowthisunrealistic.Thetransformationis
morelikelytooccurgradually,overaperiodoftime.Giventhattheassumed
totalhorizondoesnotshift(i.e.,isinfinite),thetimingoftheshiftformhigh
tostablegrowthisacriticaldeterminantofthevaluationestimate.Third,
becausethevalueisquitesensitivetothesteadystategrowthassumption,
overorunderestimatingthisratecanleadtolargeerrorsinvalue.Thetwo
modelsshareotherlimitationsaswell,notablydifficultiesinaccurately
forecastingrequiredratesofreturn,indealingwiththedistortionsthatresult
fromsubstantialand/orvolatiledebtratios,andinaccuratelyvaluingassets
thatdonotgenerateanycashflows.

25. a. Theformulaforcalculatingapriceearningsratio(P/E)forastablegrowth
firmisthedividendpayoutratiodividedbythedifferencebetweenthe
requiredrateofreturnandthegrowthrateofdividends.IftheP/Eis
calculatedbasedontrailingearnings(year0),thepayoutratioisincreasedby
thegrowthrate.IftheP/Eiscalculatedbasedonnextyearsearnings(year
1),thenumeratoristhepayoutratio.
P/E on trailing earnings:
P/E = [payout ratio (1 + g)]/(r g) = [0.30 1.13]/(0.14 0.13) = 33.9
P/Eonnextyear'searnings:
P/E = payout ratio/(r g) = 0.30/(0.14 0.13) = 30.0

b. TheP/Eratioisadecreasingfunctionofriskiness;asriskincreasestheP/E
ratiodecreases.IncreasesintheriskinessofSundancistockwouldbe
expectedtolowertheP/Eratio.
TheP/Eratioisanincreasingfunctionofthegrowthrateofthefirm;the
highertheexpectedgrowththehighertheP/Eratio.Sundanciwould
commandahigherP/Eifanalystsincreasetheexpectedgrowthrate.
TheP/Eratioisadecreasingfunctionofthemarketriskpremium.An
increasedmarketriskpremiumwouldincreasetherequiredrateofreturn,
loweringthepriceofastockrelativetoitsearnings.Ahighermarketrisk

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premiumwouldbeexpectedtolowerSundanci'sP/Eratio.

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