Question

Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $961,000. Without new projects, both firms will continue to generate earnings of $961,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 14 percent. (Do not round intermediate calculations and round your answers to 2 decimal places. (e.g., 32.16))
a. What is the current PE ratio for each company?
Price / Earnings ________________________ times
b. Pacific Energy Company has a new project that will generate additional earnings of $111,000 each year in perpetuity. Calculate the new PE ratio of the company.
Price / Earnings ________________________ times
c. U.S. Bluechips has a new project that will increase earnings by $211,000 in perpetuity. Calculate the new PE ratio of the firm.
Price / Earnings ________________________ times

Answer 1

Answer:

a.

Price / Earnings 7.04 times

b.  

Price / Earnings 7.14 times

c.  

Price / Earnings 7.14 times

Explanation:

a.

Earning = $961,000

Rate of return = 14%

PV of Perpetuity = Cash flow / rate of return

PV of Perpetuity = $961,000 / 0.14 = $6,864,286

As we know that Price is the Present value of future cash flows which is perpetuity of $6,764,286.

Price Earning Ratio = $6,764,286/ $961,000 = 7.04 times

b.

Earning = $961,000 + $111,000 = $1,072,000

Rate of return = 14%

PV of Perpetuity = Cash flow / rate of return

PV of Perpetuity = $1,072,000 / 0.14 = $7,657,143

As we know that Price is the Present value of future cash flows which is perpetuity of $7,657,143.

Price Earning Ratio = $7,657,143/ $1,072,000 = 7.14 times

c.

Earning = $961,000 + $211,000 = $1,172,000

Rate of return = 14%

PV of Perpetuity = Cash flow / rate of return

PV of Perpetuity = $1,172,000 / 0.14 = $8,371,429

As we know that Price is the Present value of future cash flows which is perpetuity of $6,764,286.

Price Earning Ratio = $8,371,429 / $1,172,000 = 7.14 times