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June 2008 past paper Ques 2 (d)
The P/E ratio of 7.5 is used to determine the Present Value of $720,000 of the after-tax savings (96,000 x 7.5 = $720,000).
How is it possible to use the P/E ratio to determine the present value?
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i cant find this number in june 2008..recheck it or send the link!!
The only reason i can think of is that Market value of shares is present value of dividends to be received, so if we’re going to make savings that leaves us with no option but to calculate their present value using P/E ratio.
It was wrong of the examiner to use the term present value in this context – P/E ratios do not replace discounting.
It is simply that using a P/E approach, the market value per share = EPS x P/E ratio.
Since we are told the extra earnings and we know the P/E ratio, we can use the line above to calculate the increase in market value.
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