Question

Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $967,000. Without new projects, both firms will continue to generate earnings of $967,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 13%.
A. What is the current PE ratio for each company?
B. Pacific Energy Company has a new project that will generate additional earnings of $117,000 each year in perpetuity. Calculate the new PE ratio of the company.
C. Atlantic Energy has a new project that will increase earnings by $217,000 in perpetuity. Calculate the new PE ratio of the firm.

Answer 1

Answer and Explanation:

The computation is shown below:

a. Current PE ratio is

For Pacific energy company

= Price ÷ Earnings

= ($967,000 ÷ 0.13) ÷ ($967,000)

= 7.69 times

For U.S Bluechips

= Price ÷ Earnings

= ($967,000 ÷ 0.13) ÷ ($967,000)

= 7.69 times

b. The new PE ratio is

= Price ÷ Earnings

= (($967,000 + $117,000) ÷ 0.13) ÷ ($967,000)

= 8.62 times

c. The new PE ratio is

= Price ÷ Earnings

= (($967,000 + $217,000) ÷ 0.13) ÷ ($967,000)

= 9.42 times