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Essentials Of Investments
Found in: Page 437
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

Explain why the following statements are true/false/uncertain.

a. With all else held constant, a firm will have a higher P/E if its beta is higher.

b. P/E will tend to be higher when ROE is higher (assuming plowback is positive).

c. P/E will tend to be higher when the plowback rate is higher.

a. False

b. True

c. Uncertain

See the step by step solution

Step by Step Solution

Step by Step Solution Step 1: Explanation of statement ‘a’

Higher beta implies that the risk and discount code applied to cash flow is higher. In this case earnings, cash flow, and price of the firm will be lower. Hence the ratio of price to earnings will be lower. Therefore this statement is false.

Step 2: Explanation of statement ‘b’

Higher ROE would mean more valuable growth opportunities. Therefore this statement is true.

Step 3: Explanation of statement ‘c’

It depends on comparison of expected rate of return with market capitalization rate. In case the expected rate of return is higher than market capitalization rate, P/E will increase. Therefore this statement is uncertain.

Most popular questions for Business-studies Textbooks

Use the following case in answering Problems 29 – 32:

Mary Smith, a Level II CFA candidate, was recently hired for an analyst position at the Bank of Ireland. Her first assignment is to examine the competitive strategies employed by various French wineries.

Smith’s report identifies four wineries that are the major players in the French wine industry. The key characteristics of each are cited in Table 12.6. In the body of Smith’s report, she includes a discussion of the competitive structure of the French wine industry. She notes that over the past five years, the French wine industry has not responded to changing consumer tastes. Profit margins have declined steadily, and the number of firms representing the industry has decreased from 10 to 4. It appears that participants in the French wine industry must consolidate in order to survive.

Smith’s report notes that French consumers have strong bargaining power over the industry.

She supports this conclusion with five key points, which she labels “Bargaining Power of Buyers”:

  • Many consumers are drinking more beer than wine with meals and on social occasions.
  • Increasing sales over the Internet have allowed consumers to better research the wines, read opinions from other customers, and identify which producers have the best prices.
  • The French wine industry is consolidating and consists of only 4 wineries today compared to 10 wineries five years ago.
  • More than 65% of the business for the French wine industry consists of purchases from restaurants. Restaurants typically make purchases in bulk, buying four to five cases of wine at a time.
  • The land where the soil is fertile enough to grow grapes necessary for the wine production process is scarce in France.

After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to review. VanDriesen tells her that he is a wine connoisseur himself and often makes purchases from the South Winery. Smith tells VanDriesen, “In my report, I have classified the South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a price that is slightly below the other firms, but it also tries to differentiate itself from its competitors by producing wine in bottles with curved necks, which increases its cost structure. The end result is that the South Winery’s profit margin gets squeezed from both sides.” VanDriesen replies, “I have met members of the management team from the South Winery at a couple of the wine conventions I have attended. I believe that the South Winery could succeed at following

both cost leadership and a differentiation strategy if its operations were separated into distinct operating units, with each unit pursuing a different competitive strategy.” Smith makes a note to do more research on generic competitive strategies to verify VanDriesen’s assertions before publishing the final draft of her report.

Which of Smith’s points effectively supports the conclusion that consumers have strong bargaining power over the industry?


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