10) During the past few years, Swanson Company has retained, on the average, 70

Question

10) During the past few years, Swanson Company has retained, on the average, 70 percent of its earnings in the business. The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected to be 10 percent. If the risk-free rate, kRF, is 8 percent, the ex¬pected return on the market, kM, is 12 percent, Swanson’s beta is 2.0, and the most recent dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Swanson’s stock today?

Explanation / Answer

Ke = Risk free rate + Beta ( Market Rate - Risk Free Rate)

= 8% + 2(12%-8%)

i.e 16%

Growth = 10%

Price of the stock = D1/Ke-G

= 1.50(1+1.10)/16%-10%

= 1.65/6% i.e 27.50

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