Exam 13: Valuation: Earnings-Based Approaches

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:

Clean surplus accounting for most common stock transactions holds for shares accounted for at market value.An exception to this is:

Todd Corp.manufactures train components.On January 1,2011,management provided the following forecast of income for the next five years: Farecisted Year Net Incame 2011 \ 3,576 2012 \ 65,853 2013 77,985 2014 \ 88,646 2015 \ 97,672 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.

Residual income is:

Porter,Inc.is a distributor of electrical supplies.Management for the company has developed the following forecasts of net income: Forecasted Year: Net Incom 2012 \ 17,450 2013 \ 22,500 2014 \ 21000 2015 \ 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: Using the residual income model, compute the value of Porter, Inc. as of January 1,2012 . Use the half-year adjustment.

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

Accounting for the residual income in a firm with 100% dividend payout can be expressed as follows: RIt = CIt- ____________________ X BVt??

What is the rationale for using expected earnings as a basis for valuations?

What is meant by the term clean surplus accounting?

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 net income includes all of the recognized elements of income for the firm for _____________________________________________.

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

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.

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

The residual income valuation model is a rigorous and straightforward valuation approach, But the analyst should be aware of all of the following implementation issues that will hinder its ability to measure firm value correctly except:

Jarrett Corp. At the end of 2010 Jarrett Corp.developed the following forecasts of net income: Forecasted Year: Net Income 2011 \2 0,856 2012 \2 2,733 2013 \2 4,552 2014 \2 7,252 2015 \ 29.978 Management believes that after 2015 Jarrett will grow at a rate of 7% each year.Total common shareholders' equity 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?

The appropriate discount rate for the residual income model is:

In many cases,using the residual income valuation model will result in a different value than either the dividend discount model or the free cash flow valuation methods.What are some reasons that the three valuation models would result in inconsistent valuations?

Jarrett Corp. At the end of 2010 Jarrett Corp.developed the following forecasts of net income: Forecasted Year: Net Income 2011 \2 0,856 2012 \2 2,733 2013 \2 4,552 2014 \2 7,252 2015 \ 29.978 Management believes that after 2015 Jarrett will grow at a rate of 7% each year.Total common shareholders' equity 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?

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).