QUESTIONS AND SHORT PROBLEMS

In the problems following, use an equity risk premium of 5.5 percent if none is specified.

1. National City Corporation, a bank holding company, reported earnings per share of $2.40 in 1993, and paid dividends per share of $1.06. The earnings had grown 7.5% a year over the prior five years, and were expected to grow 6% a year in the long term (starting in 1994). The stock had a beta of 1.05 and traded for 10 times earnings. The Treasury bond rate was 7%, and the risk premium is 5.5%.
   1. Estimate the PE ratio for National City Corporation.
   2. What long-term growth rate is implied in the firm's current PE ratio?
2. On March 11, 1994, the New York Stock Exchange Composite was trading at 16.9 times earnings, and the average dividend yield across stocks on the exchange was 2.5%. The Treasury bond rate on that date was 6.95%. The economy was expected to grow 2.5% a year, in real terms, in the long term, and the consensus estimate for inflation, in the long term, was 3.5%. (Market risk premium is 5.5%.)
   1. Based on these inputs, estimate the appropriate PE ratio for the exchange.
   2. What growth rate in dividends/earnings would justify the PE ratio on March 11,1994?
   3. Would it matter whether this higher growth comes from higher inflation or higher real growth? Why?