Chapter_05web

# Chapter_05web - EXERCISES FOR CHAPTER 5 With Solutions...

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EXERCISES FOR CHAPTER 5 With Solutions Exercise 1. Residual Earnings and Valuation The following is extracted from the income statement and balance sheet of a firm for 2001. (Amounts in \$ thousands) Operating income (after tax) 17,507 Net financial expenses 3,060 Comprehensive income 14,447 The firm paid out all income in dividends at the end of the year and there were no share issues during 2001. The book value of common equity at the end of 2001 was \$100,600. The cost of equity capital is 11%. (a) Calculate residual income for 2001. (b) The residual income for 2002 and all subsequent years is expected to be the same as in 2001. Calculate the value of the equity at the end of 2001. Residual Earnings and Valuation: Solution (a) First calculate the book value at the beginning of 2001, then calculate residual earnings earned in 2001 on this book value. Residual earnings equals comprehensive income minus a charge against the book value at 11%. Book Value (2000) = Book Value (2001) – Earnings (01) + Dividends (01) = 100,600 – 14,447 + 14,447 = 100,600

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Residual Earnings (2001) = 14,447 – (0.11 x 100,600) = 3,381 (b) Calculate the value of the equity using the residual earnings model. Value = Book Value + Present Value of RE As residual income is expected to be a perpetuity, Value = 100,600 + 11 . 0 381 , 3 = 131,336 ----------------------------------------------------------------------------------------------------------- - Exercise 2. Valuing a Project A firm announces that it will invest \$150 million in an asset that is expected to generate a 15% rate of return on its beginning-of-period book value for the next five years. The required return for this type of project is 12%; the firm depreciates the cost of assets straight-line over the life of the investment. What is the value added to the firm from this investment? Valuing a Project: Solution First calculate the book value of the asset at the beginning of each year. This is the original cost of the asset less accumulated depreciation to that year. Then calculate earnings as a 15% return on book value. Proceed to apply the residual earnings model to value the project.
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Chapter_05web - EXERCISES FOR CHAPTER 5 With Solutions...

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