Reading 45: Residual Income Valuation- LOS i～ Q1-5

common, return, required, expected, interpret

LOS i: Calculate and interpret the intrinsic value of a share of common stock using a multistage residual income model, given the required rate of return, forecasted earnings per share over a finite horizon, and forecasted continuing residual earnings.

Q1. Creative Gardening is expected to have a return on equity (ROE) of 13% for the next five years and 10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $7.50 per share and its required rate of return is 10%. The premium over book value at the end of five years is expected to be 30%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $1.10. The projected ending book value in year 5 is $13.83. What is the value of Creative Gardening using these inputs?

A) $13.83.

B) $8.60.

C) $11.18.

Q2. Valdez Plastics is expected to have a return on equity (ROE) of 15% for the next five years and 10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $8.50 per share and its required rate of return is 10 percent. The premium over book value at the end of five years is expected to be 40%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $2.10. The projected ending book value in year 5 is $17.80. What is the value of Valdez Plastics using these inputs?

A) $10.60.

B) $15.02.

C) $13.83.

Q3. Brown Manufacturing is expected to have a return on equity (ROE) of 15% for the next five years and 10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $9.50 per share and its required rate of return is 10%. The premium over book value at the end of five years is expected to be 40%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $3.10. The projected ending book value in year 5 is $25.00. What is the value of Brown Manufacturing using these inputs?

A) $12.60.

B) $13.83.

C) $18.81.

Q4. If a multistage residual income model does not consider a persistence factor, the analyst using the model is most likely assuming that residual income:

A) falls to zero over time.

B) falls to zero immediately.

C) falls to an industry norm.

Q5. Krieger String & Twine expects to generate a return on equity (ROE) of 13.6% over the next five years. The required ROE is 8.7%. Current book value is $12.40 per share. Krieger is expected to earn $1.95 per share next year, and both book value and equity are expected to rise at the rate of ROE every year for the next five years. Krieger currently assumes residual income falls to zero immediately after five years, but has now decided to recalculate its estimated value using a persistence factor of 35%. The difference between the new valuation and the old one is closest to:

A) $0.10 per share.

B) $0.45 per share.

C) $0.64 per share.