Question 1

Booker, Inc. is a distributor of building supplies. Management for the company has developed the following forecasts of net income:
 $\begin{array}{c}
\begin{array}{l}
\
\underline{\text { Year} } \
2011 \
2012 \
2013 \
2014 \
2015 
\end{array}
\begin{array}{l}
\text { Forecasted}\
\underline{\text { Net Income}}\
\$ 111,432 \
\$ 131,490 \
\$ 156,473 \
\$ 178,379 \
\$ 199,784
\end{array}
\end{array}$

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 J anuary 1,2011 .
b. Using the dividend discount model, compute the value of Booker as of J anmary 1,2011 .

Accepted Answer

The answer of Booker, Inc. is a distributor of building...

Question 2

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

Accepted Answer

1. Incomplete or inconsistent earnings and cash flow forecasts.
2. Inconsistent estimates of the weighted average costs of capital.
3. Incorrect continuing value computations.

Question 3

Provide the intuition for the residual income valuation model. In addition, define residual income.

Accepted Answer

The value of the common shareholders' equity is equal to the book value of common equity, plus the present value of all expected future residual income. Residual income is the amount by which expected future earnings exceed the required earnings, for the remaining life of the firm.

Question 4

Over the life of the firm, the present value of ______________________________, ______________________________, and ____________________ will be the same.

Accepted Answer

The answer of Over the life of the firm, the...

Question 5

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

Accepted Answer

A)   exactly equal to the book value of common shareholders' equity.
B)   greater than the book value of common shareholders' equity.
C)   less than the book value of common shareholders' equity.
D)   exactly equal to working capital.

Question 6

Over sufficiently long periods, _________________________ equals free cash flows to common equity.

Accepted Answer

The answer of Over sufficiently long periods, _________________________ equals free...

Question 7

Explain residual income. What does residual income represent? What does residual income measure?

Accepted Answer

The answer of Explain residual income. What does residual income...

Question 8

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

Accepted Answer

The answer of What is the rationale for using expected...

Question 9

Jarrett Corp. 
At the end of 2010 Jarrett Corp. developed the following forecasts of net income:
$\begin{array}{c}
\begin{array}{l}
\
\text { Year } \
2011 \
2012 \
2013 \
2014 \
2015 
\end{array}
\begin{array}{l}
\text { Forecasted}\
\text { Net Income}\
\$ 20,856 \
\$ 22,733 \
\$ 24,552 \
\$ 27,252 \
\$ 29,978 
\end{array}
\end{array}$

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%.
-
Compute the value of Jarrett Corp. on January 1, 2011, using the residual income valuation model. Use the half-year adjustment.

Accepted Answer

A)   $112,768
B)   $185,329
C)   $195,540
D)   $133,624

Question 10

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).

Accepted Answer

The answer of Investors have invested $25,000 in common equity...

Question 11

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?

Accepted Answer

A)   $25,000
B)   $26,350
C)   $26,151
D)   $26,041

Question 12

Explain required income. What does required income represent? How is required income conceptually analogous to interest expense?

Accepted Answer

The answer of Explain required income. What does required income...

Question 13

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

Accepted Answer

A)   dynamic residual income
B)   realistic residual income
C)   continuing residual income
D)   equilibrium residual income.

Question 14

__________________ means that net income includes all of the recognized elements of income of the firm for common equity shareholders and dividends include all direct capital transactions between the firm and the common equity shareholders.

Accepted Answer

The answer of __________________ means that net income includes all...

Question 15

What are the three arguments economists provide against using earnings as a value-relevant attribute in valuation?

Accepted Answer

The answer of What are the three arguments economists provide...

Question 16

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 earns $4,000 the first year. For this company determine the following:
 a. The companys srequired earnings
b. The company'sre sichal earnings

Accepted Answer

The answer of Investors have invested $25,000 in common equity...

Question 17

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?

Accepted Answer

A)   $2,100
B)   $15,700
C)   $14,600
D)   $16,800

Question 18

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.

Accepted Answer

The answer of If an analyst expects a firm to...

Question 19

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?

Accepted Answer

The answer of Why is it appropriate to use the...

Question 20

What is meant by the term clean surplus accounting?

Accepted Answer

The answer of What is meant by the term clean...

Exam 13: Valuation: Earnings-Based Approaches