Please answer all parts correctly. Consider a company A with zero earnings reten

Question

Please answer all parts correctly.

Consider a company A with zero earnings retention ratio and a real growth rate in earnings of gamma percent. In an inflation environment, the company can only pass inflation through its earnings at a flow-through rate of lambda percent. So if I is the inflation rate, its earnings will growth at a rate of g = gamma + lambda I. The real rate of return required for this company is rho, so the nominal rate of return required is r = rho +I. Use a discounted dividend model and assume that dividends will grow indefinitely at a constant compounded annual growth rate, g = gamma + lambda I. Suppose earning in the current period is denoted E_0. State an expression for earnings in the next period E_1. Using an appropriate formula, show clearly with workings how you arrive at an expression for the intrinsic P/E using the prospective earnings. (Obtain an expression for P_0/E_1). Using the expression for the intrinsic P/E you obtained in part (b), explain the relationships between inflation pass through rate and the price of the company (or stock price). the real growth rate in earnings and the P/E ratio. Calculate the P/E ratio on company A's prospective earnings given gamma = 2%, I=rho = 4% and lambda= 100%. What is the implication on company A's P/E ratio if the inflation pass through rate is only 80%? Explain. Suppose the inflation pass through rate is 100% and the inflation rate is exactly equal to the real growth rate in earnings. What can you infer about the intrinsic P/E? Explain.

Explanation / Answer

The Earning in this period will be given by

g= y + (lambda) *I

If the earnings were E0 previusly then it would be = E0*(1+g)

= E0*(1+ y+ (lambda)*I)

2. The required rate of return will be given by = p + I

As it has zero earnings retention ratio it would give

E1 = D1 = E0*(1+ y+ (lambda)*I)

required return = p+ I

growth = y+(Lanbda)I

=P0 =E1/(reqired reurn - growth) = E0*(1+ y+ (lambda)*I)/(P+ I - Y+ (Lambda)*I)

P0/E1 =1/ (P+ I - Y- (Lambda)*I)

If inflation pass through rate increas P/E ratio would increase and also the price of the company

Real groeth rate increase P/E ration would increase

d) P/E ratio-

=1/(4% +4%-2%-100%*4%)

=1/2% = 50

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