Assume you expect the company’s income to be $3000 in the coming year and to except the 5% income growth rate (and beginning of year common equity to support it) is only expected for years 3 and 4. Then growth is expected to be zero and all income is expected to be distributed to shareholders for all future years. Assume the company is an all-equity firm; that is, all financing comes from stockholders, and none comes from debtholders. In this case, the company’s balance sheet has net operating assets (NOA) of $14 000, shareholders’ equity of $14 000, and zero net financial obligations (zero net debt). Required: a) Compute residual income (i.e., abnormal earnings) for the next three years, and verify that residual income is growing at a constant rate. What is that rate of growth? b) Use the residual income (abnormal earnings) model to derive the value of the firm and the price per common share.
Assume you expect the company’s income to be $3000 in the coming year and to except the 5% income growth rate (and beginning of year common equity to support it) is only expected for years 3 and 4. Then growth is expected to be zero and all income is expected to be distributed to shareholders for all future years. Assume the company is an all-equity firm; that is, all financing comes from stockholders, and none comes from debtholders. In this case, the company’s balance sheet has net operating assets (NOA) of $14 000, shareholders’ equity of $14 000, and zero net financial obligations (zero net debt).
Required:
a) Compute residual income (i.e., abnormal earnings) for the next three years, and verify that residual income is growing at a constant rate. What is that rate of growth?
b) Use the residual income (abnormal earnings) model to derive the value of the firm and the price per common share.
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