Exam 13: Valuation: Earnings-Based Approaches

Residual income is

Todd Corp.manufactures train components.On January 1,2011,management provided the following forecast of income for the next five years: Year Farectisted 2011 Net Income 2012 \ 53,576 2013 \ 65,853 2014 \ 7,985 2015 \ 88,646 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.

The appropriate discount rate for the residual income model 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 amounts in millions) Amore Infact Tickle Total Assets \ 42,419 \ 109,524 \ 44,106 Common Equity: Book Value \ 17,480 \ 13,466 \ 13,712 Market Value \ 83,050 \ 166,420 \ 34,600 Market Equity Beta 0.27 0.73 1.09 Analysts' Consensus Forecasts of Net Income for Year +1 \ 5,750 \ 12,956 \ 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.

If an analyst expects a firm to generate net income each period exactly equal to required earnings,then the value of the firm will be equal to the ______________________________ of common shareholders' equity.

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

Accounting principles make accrual accounting earnings closer to the firm's underlying economic performance in a given period than are _________________________.

Residual income in a long-run steady-state growth period is referred to as:

Where is comprehensive income reported and what is its relevancy to the computation of residual income?

Dirty surplus items in U.S.GAAP typically arise from all of the following except:

The foundation for residual income valuation is the classical _____________________________________________.

Booker,Inc.is a distributor of building supplies.Management for the company has developed the following forecasts of net income: Management expects net income to grow at a rate of 7 percent per year after 2015 and the company's cost of equity capital is 14%.Management has set a dividend payout ratio equal to 25% of net income and plans to continue this policy.Booker's common shareholders' equity at January 1,2011 is $544,902. Required:a.Using the residual income model,compute the value of Booker as of January 1,2011. b.Using the dividend discount model,compute the value of Booker as of January 1,2011.

The residual income valuation approach assumes that accounting for net income and book value of shareholders' equity follows ________________________________________.

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

Jarrett Corp. At the end of 2010 Jarrett Corp. developed the following forecasts of net income: 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%. -Assume that a firm's book value at the beginning of the year is $12,500 and that the firm reports net income of $3,200 and pays dividends of $1,100.What will the firm's book value at the end of the year?

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?

Investors have invested $25,000 in common equity in a company.Given the risk inherent in the company the investors expect to earn a 15 percent return.In addition,the investors expect that the company will reinvest all income in projects that will earn 16%.The company is forecasted to earn $6,000 the first year,$5,000 the second year,$5,500 the third year and $6,244 each year after the third year.For this company determine the company's residual income valuation (round all numbers to the nearest dollar).

At the beginning of 2012 investors had invested $25,000 of common equity in Grant Corp.and expect to earn a return of 11% per year.In addition,investors expect Grant Corp.to pay out 100% of income in dividends each year.Forecasts of Grant's net income are as follows: 2012 - $3,500 2013 - $3,200 2014 - $2,900 2015 and beyond - $2,750 Using this information what is Grant's residual income valuation at the beginning of 2012?

Why is it appropriate to use the required rate of return on equity capital (rather than the weighted average cost of capital)as the discount rate in the residual income valuation approach?

Investors have invested $25,000 in common equity in a company.Given the risk inherent in the company the investors expect to earn a 15 percent return.In addition,the investors expect the company to return all income to investors in the form of dividends.The company is forecasted to earn $4,000 the first year,$5,000 the second year,$4,500 the third year and $3,750 each year after the third year.For this company determine the company's residual income valuation