Q:
A:
Which
of the following events would cause an increase in
a firm's P/E ratio, assuming that everything else
is held constant?
a) An increase in the Treasury bill yield.
b) A drop in the growth rate of earnings.
c) A drop in the Treasury bill yield.
d) A drop in the dividend payout ratio of the firm.
a) An increase in the Treasury bill yield.
b) A drop in the growth rate of earnings.
c) A drop in the Treasury bill yield.
d) A drop in the dividend payout ratio of the firm.
The correct answer is: c)
The constant growth rate model is as follows:
P = D1/(k  g)
Therefore, by dividing both side by earnings (E), we get:
P/E = (D1/E)/(kg)
As the risk free rate of return (or the Treasury bill yield) decreases, investors will begin to require a lower rate of return on all other investments. (This is because the Tbill yield serves as a benchmark for the required return on all investments). However, as the required rate of return (k) decreases, the whole of the right side of the equation increases, and therefore, the left side (PE) must increase as well.
The constant growth rate model is as follows:
P = D1/(k  g)
Therefore, by dividing both side by earnings (E), we get:
P/E = (D1/E)/(kg)
As the risk free rate of return (or the Treasury bill yield) decreases, investors will begin to require a lower rate of return on all other investments. (This is because the Tbill yield serves as a benchmark for the required return on all investments). However, as the required rate of return (k) decreases, the whole of the right side of the equation increases, and therefore, the left side (PE) must increase as well.
CFA Level 1 2005 LOS: 14.1.A.g and h, 14.1.B.b
MORE FAQS

Which of the following statements is (are) true with respect to priceearnings (P/E) multiples ...

What's the difference between absolute P/E ratio and relative P/E ratio?

What is the average pricetoearnings ratio in the banking sector?

What does the forward p/e indicate about a company?

How do I calculate the P/E ratio of a company?

Stocks with high P/E ratios can be overpriced. Is a stock with a lower P/E always a better investment than a stock with a higher one?

How can the pricetoearnings (P/E) ratio mislead investors?

What is an alternative ratio to forward p/e?

What does it mean if a bond has a zero coupon rate?

What is the difference between forward p/e and trailing p/e?

How can I find the P/E ratio on an ETF's underlying index?

Where can I find the P/E ratios for the Dow and S&P 500?

How do companies benefit from price discrimination?

What is the average pricetoearnings ratio in the oil & gas drilling sector?

How many attempts at each CFA exam is a candidate permitted?

Do financial advisors need to pass the Series 7 exam?

Do financial advisors need to be approved by FINRA?

How does a broker decide which customers are eligible to open a margin account?

Why is the Nasdaq more heavily weighted to tech stocks than other stock exchanges?
RELATED FAQS

Which of the following statements is (are) true with respect to priceearnings (P/E) ...
The correct answer is: b) The reason choice I is true is because during a recession, corporate earnings will generally fall ... 
What's the difference between absolute P/E ratio and relative P/E ratio?
The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock ... 
What is the average pricetoearnings ratio in the banking sector?
Explore the price/earnings ratio in regard to the banking industry and learn what the average P/E ratio is for most banking ... 
What does the forward p/e indicate about a company?
Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... 
How do I calculate the P/E ratio of a company?
Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance.
RELATED TERMS

Earnings Yield
The earnings per share for the most recent 12month period divided ... 
PriceEarnings Ratio  P/E Ratio
The PricetoEarnings Ratio or P/E ratio is a ratio for valuing ... 
Forward Price To Earnings  Forward P/E
A measure of the pricetoearnings ratio (P/E) using forecasted ... 
P/E 30 Ratio
The pricetoearnings (P/E) ratio is the valuation ratio of a ... 
Trailing PriceToEarnings  Trailing P/E
The sum of a company's pricetoearnings, calculated by taking ... 
P/E 10 Ratio
A valuation measure, generally applied to broad equity indices, ...