Exam 13: Valuation: Earnings-Based Approaches

When debating the issue of whether to use free cash flows or earnings in a valuation model, economists sometimes argue that ____________________ can be subject to purposeful management by a firm and thus make them less useful.

____________________ are the fundamental, value-relevant attribute of expected future returns.

The appropriate discount rate for the residual income model is

Residual income is

The following data represent total assets, book value, and market value of common shareholders' equity for Amore, Infact, and Tickle. Amore manufactures and sells cosmetics. Infact develops and manufactures computer chips. Tickle operates a chain of general merchandise stores. In addition, these data include existing market betas for the three firms and analysts' consensus forecasts of net income for Year +1 Assume that for each firm, analysts expect other comprehensive income items for Year +1 to be zero; so Year +1 net income and comprehensive income will be identical. Assume that the risk-free rate of return in the economy is 4.5 percent and the market risk premium is 5.5 percent. (dollar anounts in millions) Total Assets Common Equity: Book Value Market Value Market Equity Beta Analysts' Consensus Forecasts of Net Income for Year +1 Amore \ 42,419 \ 17,480 \ 83,050 \ .27 \ 5,750 Infact \ 109,524 \ 13,466 \ 166,420 0.73 \ 12,956 Tickle \ 44,106 \ 13,712 \ 34,600 1.09 \ 2,384 Required a. Using the CAPM, compute the required rate of return on equity capital for each firm. b. Project required income for Year +1 for each firm. c. Project residual income for Year +1 for each firm. d. What do the different amounts of residual income imply about each firm? Do the projected residual income amounts help explain the differences in market value of equity across these three firms? Explain.

Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,600 at the end of 2010. During 2011 the firm earns net income of $1,300, pays dividends to shareholders of $600, and uses $300 to repurchase common shares. The book value of shareholders equity at the end of 2011 is:

Porter, Inc. is a distributor of electrical supplies. Management for the company has developed the following forecasts of net income: 2012 2013 2014 2015 2016 Furetithed \ 17,450 \ 72,500 \ 76,000 \ 71,000 \ 18,500 Fred King, CFO of Porter, Inc., expects net income to grow at a rate of 9 percent per year after 2016 and the company's cost of equity capital is 15%. Management plans to pay out all income in dividends and plans to continue this policy into the future. Porter's common shareholders' equity at January 1, 2011 is $100,000. Required: $\text { Using the residual income model, compute the value of Porter, Inc. as of J anuary } 1,2012 \text {. Use the half-year adjustment. }$

Jarrett Corp. At the end of 2010 Jarrett Corp. developed the following forecasts of net income: Year 2011 2012 2013 2014 2015 Forecasted Net Income \ 20,856 \ 22,733 \ 24,552 \ 27,252 \ 29,978 Management believes that after 2015 Jarrett will grow at a rate of 7% each year. Total common shareholders' was $112,768 on December 31, 2010. Jarrett has not established a dividend and does not plan to paying dividends during 2011 to 2015. Its cost of equity capital is 12%. - What would be Jarrett's common shareholders' equity at the end of 2014?

The required earnings of the firm equals the product of the required rate of return on common equity capital times the __________________________________________________ at the beginning of the period.

Clean surplus accounting means that ____________________ include all direct capital transactions between the firm and the common equity shareholders.

The foundation for residual income valuation is the classical _____________________________________________.

Todd Corp. manufactures train components. On January 1, 2011, management provided the following forecast of income for the next five years: Year 2011 2012 2013 2014 2015 Forecasted Net Income \ 54,252 \ 64,017 \ 76,181 \ 86,846 \ 97,267 Thomas' common shareholders' equity was $422,174 on January 1, 2011. The firm does not expect to pay a dividend during the 2011-2015 period. Thomas' cost of equity capital is 11 percent. Required: Compute the value of Todd Company on January 1, 2011, using the residual income valuation model and the half year convention. T. Harp, the CEO of Todd, expects net income to grow at a rate of 6 percent annually after 2015.

In some industries, competitive dynamics eventually drive long-run projections of the future returns earned by the firm to an equilibrium level equal to the long-run expected cost of equity capital in the firm. At that point, a firm can be expected to earn ____________ residual income in the future.

Why is the weighted average cost of capital not used as the discount rate when computing residual income?

The two most popular discounted earnings models appear to be

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect the ______________________________ to the shareholders.

If the firm competes in a very competitive, mature industry, what effect will competitive conditions have on residual income for the firm and others in the industry? Now suppose the firm holds a competitive advantage in an industry, but the advantage is not likely to be sustainable for more than a few years because of the potential for entry in the industry. As the firm's competitive advantage diminishes, what effect will that have on that firm's residual income?

Jarrett Corp. At the end of 2010 Jarrett Corp. developed the following forecasts of net income: Year 2011 2012 2013 2014 2015 Forecasted Net Income \ 20,856 \ 22,733 \ 24,552 \ 27,252 \ 29,978 Management believes that after 2015 Jarrett will grow at a rate of 7% each year. Total common shareholders' was $112,768 on December 31, 2010. Jarrett has not established a dividend and does not plan to paying dividends during 2011 to 2015. Its cost of equity capital is 12%. - What would be Jarrett's residual income in 2013?

Economists sometimes argue that earnings are not a _________________________ attribute on which to base valuation.