Question 1

The following are earnings and dividend forecasts made at the end of 2012 for a
firm with $20.00 book value per common share at that time. The firm has a
required equity return of 10 percent per year.

2013 2014 2015

EPS 3.00 3.60 4.10
DPS 0.25 0.25 0.30

a. Forecast return of common equity (ROCE) and residual earnings for each year,
2013- 2015.

b. Based on your forecasts, do you think this firm is worth more or less than book
value? Why?

Question 2

The following are ROCE forecasts made for a firm at the end of 2010.

2011 2012 2013

Return of 12.0% 12.0% 12.0%
common
equity
(ROCE)

ROCE is expected to continue at the same level after 2013. The firm reported book
value of common equity of $3.2 billion at the end of 2010, with 500 million shares
outstanding. If the required equity return is 12 percent, what is the per-share value of
these shares?

Question 3

An analyst presents you with the following pro forma (in millions of dollars) that
gives her forecast of earnings and dividends for 2013-2017. She asks you to value the
1,380 million shares outstanding at the end of 2012, when common shareholders'
equity stood at $4,310 million. Use a required return for equity of 10 percent in your
calculations.

2013E 2014E 2015E 2016E 2017E

Earnings 388.0 570.0 599.0 629.0 660.4
Dividends 115.0 160.0 349.0 367.0 385.4

a. Forecast book value, return on common equity (ROCE), and residual earnings for
each of the years 2013- 2017.

b. Forecast growth rates for book value and residual earnings for each of the years
2014- 2017.
c. Calculate the per-share value of the equity from this pro forma. Would you call
this a Case 1, 2, or 3 valuation?

d. What is the premium over book value given by your calculation? What is the P/B
ratio?

Question 4

The following forecasts of earnings per share (EPS) and dividend per share (DPS)
were made at the end of 2012 for a firm with a book value per share of $22.00:

2013E 2014E 2015E 2016E 2017E

EPS 3.90 3.70 3.31 3.59 3.90
DPS 1.00 1.00 1.00 1.00 1.00

The firm has an equity cost of capital of 12 percent per annum.

a. Calculate the residual earnings that are forecast for each year, 2013 to 2017.

b. What is the per-share value of the equity at the end of 2012 based on the residual
income valuation model?

c. What is the forecasted per-share value of the equity at the end of the year 2017?

d. What is the expected premium in 2017?

Question 5

Black Hills Corporation is a diversified energy corporation and a public utility holding
company. The following gives the firm's earnings per share and dividends per share
for the years 2000-2004.

1999 2000 2001 2002 2003 2004

EPS 2.39 3.45 2.28 2.00 1.71
DPS 1.06 1.12 1.16 1.22 1.24
BPS 9.96

Suppose these numbers were given to you at the end of 1999, as forecasts, when the
book value per share was $9.96, as indicated. Use a required return of 11 percent for
calculations below.

a. Calculate residual earnings and return of common equity (ROCE) for each year,
2000-2004.

b. Based on your analysis, give a target price at the end of 2004.

Question 6

In September 2008 the shares of Dell, Inc., the computer maker, traded at $20.50
each. In its last annual report, Dell had reported book value of $3,735 million with
2,060 million shares outstanding. Analysts were forecasting earnings per share of
$1.47 for fiscal year 2009 and $1.77 for 2010 Dell pays no dividends. Calculate the
per-share value of Dell in 2008 based on the analysts' forecasts, with an additional
forecast that residual earnings will grow at the anticipated GDP growth rate of 4
percent per year after 20l0. Use a required return of 10 percent.

Question 7

In April 2005, General Motors traded at $28 per share on book value of $49 per share.
Analysts were estimating that GM would earn 69 cents per share for the year ending
December 2005. The firm was paying an annual dividend at the time of $2.00 per
share.

a. Calculate the price-to-book ratio (P/B) and the return on common equity (ROCE)
that analysts were forecasting for 2005.

b. Is the P/B ratio justified by the forecasted ROCE?

c. An analyst trumpeted the high dividend yield as a reason to buy the stock.
(Dividend yield is dividend/price.) "A dividend yield of over 7 percent is too juicy to
pass up," he claimed. Would you rather focus on the ROCE or on the dividend yield?

Answer :

1. a. Given Book Value = $20.00 Required Equity Return = 10% We know, Residual
Incomet, RIt = EPSt - ROE x Bt-1 RI2010 = 3.0 - 0.1 x B2009 = 3.0 - 0.1x20 = 3.0 - 2.0
=$1.0 B2010 = Opening

b.

2.

3. 2013E 2014E 2015E 2016E 2017E

Earnings 388.0 570.0 599.0 629.0 660.4

Dividends 115.0 160.0 349.0 367.0 385,4

Book value 4,583.0 4,993.0 5,243,0 5,505.0 5,780.0

ROCE 9.0% 12.4% 12.0% 12.0% 12.0%

Residual earnings-43.0 111.7 99.7 104.7 109.9

Growth in RE -10.7% 5.0% 5.0%

Growth in Book value 8.9% 5.0% 5.0% 5.0%

Discount factor 1.110 1.210 1.331 1.464 1.611

PV of RE -39.1 92.3 74.9

a. Forecasted book values, ROCE, and residual earnings are given in the

completed pro forma above. Book value each year is the prior book value
 plus earnings and minus dividends for the year. So, for 2014 for example,

Book value = 4583 +570 –160 = 4,993.

The starting book value (in 2012) is 4,310. Residual earnings for each year

is earnings charged with the required return in book value. So, for 2014,

RE is 570 – (0.10 × 4,583) = 111.7.

b. Forecasted growth rates in book value and residual earnings are given above.

c. The growth rate in residual earnings is 5% after 2015. Assuming this growth

rate will continue into the future, the valuation is a Case 3 valuation with the

continuing value calculated at the end of 2015:

Book value, 2012 4,310.0

Total present value of RE to 2006 (from last line above) 128.1
104.7
Continuing value (CV), 2015: 1.10 1.05  2094.0

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2012 6,011.4

Per share value (on 1,380 million shares) 4.36

The premium is 6,011.4 – 4,310 = 1,701.4, or 1.23 on a per-share basis. The

P/B ratio is 6,011.4/4,310 = 1.39.

d.

4. 2012E 2013E 2014E 2015E 2016E 2017E

Eps 3.90 3.70 3.31 3.59 3.90
Dps 1.00 1.00 1.00 1.00 1.00
Bps 22.00 24.90 27.60 29.91 32.50 35.40

(a) RE (0.12) 1.26 71 0 0 0

Discount rate 1.12 1,2544
PV 1.125 57
Total PV 1.70
(b) Value 23.70
(c) As residual earnings are expected to be zero after 2017, the equity is expected
to be worth its book value of $35.40. That is no premium is expected at 2017
An aside : The calculation can also be made by forecasting the cum – dividend
book value in 2017 and reducing it by the value of dividends to be paid out (to
get an ex – dividend price) :
Expected cum-dividend value in 2017 VTE TV0E=1.125 × 23.70
= 41.77

Terminal value of the dividend payoff at 2012E:

 2012E div: 1.00 × 1.5735 = 1.57

2013E div: 1.00 × 1.4049 = 1.41

2014E div: 1.00 × 1.2544 = 1.25

2015E div: 1.00 × 1.12 = 1.12

2016E div: 1.00 × 1.00 1.00 6.35

Expected ex-dividend value at 2017 35.42

(d) The expected premium at 2017E is zero because subsequent residual income

is expected to be zero. Knowing this, you can calculate the expected price at

2017E as equal to the expected book value at that date: $35.42. This is a

much shorter calculation!

(e) The dividend discount formula can be applied because we now have a basis

for calculating its terminal value. The terminal value is the expected terminal

price, and this can be calculated at the end of 2014E because, at this point,

expected price equals book value.

V0E  t d t  TVT / T

t1

The TV2001 is given by the expected 2001 book value:

TV2002 = 27.60

So the calculation goes as follows:

1999 2000 2001

Dps 1.00 1.00

PV .89 .80
Total PV of divs. 1.69
TV 27.60
PV of TV 22.00
Value 23.69

Note that, as price is expected to equal book value at the end of 2014E, then we can

also get the current value by taking the present value of the cum-dividend terminal
book value:

As
V1999E = Cum-dividend 2001 value/1.122

and as

Cum-dividend 2014E value = cum-dividend 2014E book value

then

VE = cum-dividend 2014E book value/1.122

1999

Terminal value of 2000 and 2001 divs at end of 2001 = 2.12

Expected 2014E book value = 27.60

Expected 2014E cum-dividend book value 29.72

PV = 29.72/1.122 = 23.69

5. The pro forma for the exercise is as follows:

Forecast Year
1999 2000 2001 2002 2003 2004
Eps 2.39 3.45 2.28 2.00 1.71
Dps 1.06 1.12 1.16 1.22 1,24
Bps 9.96 11.29 13.62 14.74 15.52 15.99
ROCE 24.0% 30.6% 16.7% 13.6% 11.0%
RE (11% charge) 1.294 2.208 0.782 0.379 0.003
Discount rate (1.11)t 1.110 1.232 1.368 1.518 1.685
Present value of RE 1.166 1.792 0.572 0.250 0.002
Total present value of RE to 2004 3.78
Continuing value (CV) 0.0
Present value of CV 0.00
Value per share 13.74

a. ROCE and residual earnings are in the pro forma

b. If ROCE is to continue at 11% after 2004, then residual earnings are expected
to be zero. The continuing value is zero. The value is $13.74 per share.

6. The pro forma for 2009 and 2010 and the value it implies is as follows :
2008 2009 2010
EPS 1.47 1.77
DPS 0.00 0.00
BPS 1.813 3.283 5.053
RE (10%) 1.289 1.442
Discount rate 1.10 1.21
PV of RE 1.172 1.192
Total PV to 2010 2.364
Continuing value 24.99
1.442 x 1.04
 1.10 – 1.04
PV of continuing value 20.66
Value per share 24.84
Note: BPS at the end of fiscal-year 2008 = $3,735/2,060 shares = $1.813.

Q3 Creating Earnings and Valuing Created Earnings

Value the following project at the start of 2017 using the residual income model.
Value theproject for each of the two alternate accounting approaches and
provide an explanation fort h e d i f f e r e n c e i n t h e t w o v a l u a t i o n a m o u n t s .
T h e i n v e s t m e n t s h o u l d b e d e p r e c i a t e d (expensed) in the same period in
which the revenues are expected to arise.

Accounting Treatment One

Assume the firm invested $400 in the project in 2016 and it is expected to
generate $440revenue one year later in 2017. The required return is 10 percent.
Accounting Treatment Two
Now assume exactly the same project with same payoffs but the accounting
is different.Specifically, assume that the accountant wrote down the investment
to $360 on the balancesheet in the prior period (2016). This is because the
investment consists of $360 of plant(booked to the balance sheet) and $40
advertising (which cannot be booked to the balancesheet under GAAP).
Revenues of $440 are expected from the project and the required returnis 10
percent.

7. a. P/B = 28/49 = 0.57 ; ROCE = 0.69/49 = 1.41%

b.
c.