Explanation:

The correct answer is B (6.7%). The justified forward P/E ratio is calculated as:

$\text{Justified P/E} = \frac{p}{r - g}$

where:

• $p$ = payout ratio = $1 - \text{retention rate} = 1 - 0.60 = 0.40$
• $r$ = required rate of return = nominal risk-free rate + risk premium = $0.025 + 0.06 = 0.085$
• $g$ = dividend growth rate

Given the P/E ratio of 22:

$22 = \frac{0.40}{0.085 - g}$

Solving for $g$:

$0.085 - g = \frac{0.40}{22}$ $0.085 - g = 0.01818$ $g = 0.085 - 0.01818 = 0.0668 \text{ or } 6.7\%$

Why not A or C?

• A (5.8%) is incorrect because it mistakenly uses the retention rate instead of the payout ratio.
• C (7.4%) is incorrect because it uses the current stock price instead of the P/E ratio to solve for $g$.