The investor’s required rate of return is 13.5 percent. The expected level of earnings at the end of this year (E1) is $6.00. The retention ratio is 50 percent. The return on equity (ROE) is 15 percent (that is, it can earn 15 percent on reinvested earnings). Similar shares of stock sell at multiples of 16.667 times earnings per share.

a. Determine the expected growth rate for dividends.
b. Determine the price/earnings ratio (P/E1) using Equation (10–5a).
c. What is the stock price using the P/E ratio valuation method?
d. What is the stock price using the dividend discount model?
e. What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 60 percent (holding all else constant)? What would happen to the P/E ratio (P/E1) and stock price if the company paid out all its earnings in the form of dividends?
f. What have you learned about the relationship between the retention rate and the P/E ratio?