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1) Bank A pays 18
1) Bank A pays 18.4% interest compounded semi-annually (i.e. every six months), while Bank B pays 17.9% interest compounded daily. Which of the following represent the actual annual returns earned in Bank A and Bank B?
2) Diry Industries is considering expanding into a new product line. Earnings per share are expected to be $5 in the current year and are expected to grow annually at 7% if the new product line is introduced. The dividend payout ratio is 80%. If Diry's equity cost of capital is 12%, what would be the company's stock price if they introduce the new product line? What would be the price earning ratio?
Expert Solution
1) Computation of the actual annual returns:-
Bank A ;
EAR = (1+rate/n)^n-1
Here, n = 2 periods (semiannual)
EAR = (1+18.4%/2)^2-1
= 1.1925 - 1
= 19.25%
Bank B ;
EAR = (1+rate/n)^n-1
Here, n = 365 periods (compounding daily)
EAR = (1+17.9%/365)^365-1
= 1.1960 - 1
= 19.60%
2) Computation of the company's stock price:-
Dividend = Earnings * Dividend payout ratio
= $5 * 80%
= $4
Stock price = D1 / (Cost of capital - Growth rate)
= $4 / (12% - 7%)
= $4 / 5%
= $80
Computation of the price earning ratio:-
P/E ratio = Price of stock / Earnings
= $80 / $5
= 16 times
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