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Robert Higgins is estimating the price-earnings (P/E) ratio that will be appropriate for an index at the end of next year. He has estimated that:

•Expected annual dividends will increase by 10% compared to this year. Expected earnings per share will increase by 10% compared to this year.

The expected growth rate of dividends will be the same as the current estimate of 5%.

• The required rate of return will rise from 8% to 11%.

Compared to the current P/E, the end-of-the-year P/E will be:

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Question:

•Expected annual dividends will increase by 10% compared to this year. Expected earnings per share will increase by 10% compared to this year.

The expected growth rate of dividends will be the same as the current estimate of 5%.

• The required rate of return will rise from 8% to 11%.

Compared to the current P/E, the end-of-the-year P/E will be:

A
50% lower.

explanation

The numerator of the formula for the P/E is the payout ratio, which is unchanged (both expected earnings and dividends increase by the same percentage). The denominator (k — g) doubles from 3% to 6%, which will decrease the PIE by half .

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