Answer:

Compute return on earnings (ROE)

ROE = Net income / Equity

= $875,000 / $7,300,000

= 0.1199 or 11.99%

Compute dividend payout ratio

Dividend payout ratio = Dividends / Net income

= $345,000 / $875,000

= 0.3942 or 39.42%

Compute retention ratio

Retention ratio = 1 - Dividend payout ratio

= 1 - 0.3942

= 0.6058 or 60.58%

Compute sustainable growth rate

Sustainable growth rate = ROE * Retention ratio / 1 - (ROE * Retention ratio)

= 0.1199*0.6058 / 1 - (0.1199 * 0.6058)

= 0.0726 / 0.9274

= 0.0783 or 7.83%

Compute current earnings per share value EPS_0.

EPS₀ = Net income / Shares outstanding

= $875,000 / 125,000 shares

= $7.00

Compute next year earnings per share, EPS₁

EPS₁ = EPS₀ * (1 + g)

= $7.00 * (1+0.0783)

= $7.00 * 1.0783

= $7.55

Compute target stock price P₁

P₁ = (Benchmark P/E ratio * EPS₁)

= 16*$7.55

= $120.80