Consider Company a with a Zero Earnings Retention Ratio and a Real

question 10

Essay

Consider Company A with a zero earnings retention ratio and a real growth rate in earnings of
$\gamma$ %. In an inflationary environment, the company can only pass inflation through its earnings
at a flow-through rate of $\lambda$ %. So if I is the inflation rate, its earnings will grow at a rate of
g = $\gamma$ + $\lambda$ I. The real rate of return required for this company is $\rho$ , so the nominal rate of return required is r== $\rho$ + I.
Use a simple dividend discount model (DDM) assuming that dividends will grow indefinitely at a constant compounded annual growth rate (CAGR), g = $\gamma$ + $\lambda$ I.
a. Derive formulas equivalent of Equations (6.7) and (6.8), which assumed no real growth in earnings. Discuss the results.
b. Use these formulas to calculate P/E ratio on prospective earnings with the following data on Company A: $\gamma$ = 2%, I = 4%, $\rho$ = 4%, $\lambda$ = 100%.
c. Same question for a Company B, whose inflation pass-through rate is only 80%.

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Definitions:

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