Chapter 7 The Role of Financial Information in Valuation and Credit Risk Assessment

Assigned problem or case: Problem or case title: Tab

P7-9 Calculating value creation by two companies P7-9

C7-1 Illinois Tool Works: Valuing abnormal earnings C7-1
P7-9 Calculating value creation by two companies

This spreadsheet consists of:

1) Data table for company A (beginning row 8)
2) Data table for company B (beginning row 19)

Company A 20X1 20X2 20X3 20X4 20X5

X-1 $ 66,920 $ 79,632 $ 83,314 $ 89,920 $ 92,690
BVt-1 $ 478,000 $ 504,000 $ 541,000 $ 562,000 $ 598,000
Cost of equity capital 0.152 0.167 0.159 0.172 0.166
Return on Capital 0.140 0.016 0.154 0.160 0.155
Abnormal Earnings $ (5,736) $ (4,536) $ (2,705) $ (6,744) $ (6,758)

Company B 20X1 20X2 20X3 20X4 20X5

X-1 $ 192,940 $ 176,341 $ 227,700 $ 198,900 $ 282,964
BVt-1 $ 877,000 $ 943,000 $ 989,999 $ 1,020,000 $ 1,199,000
Cost of equity capital 0.188 0.179 0.183 0.175 0.186
Return on Capital 0.220 0.179 0.230 0.195 0.236
Abnormal Earnings $ 28,064 $ 7,544 $ 46,530 $ 20,400 $ 59,950

Company B created value each year via positive abnormal earnings, while Company A actually des

The return investors earn from a stock depends on the difference between what must paid to buy th
pany A actually destroyed value each year by earning negative abnormal earnings.

must paid to buy the stock—it’s cost or current market price—and what it will ultimately be worth at the time it is sold—it’s value,
me it is sold—it’s value, expressed in current dollars. In an efficient market, the current price (“cost”) of each stock is equal to wha
ch stock is equal to what the stock is worth today. Exceptional investment returns are earned only if the stock is somehow mispri
tock is somehow mispriced currently.
C7-1 Abnormal Earnings Valuation

Abnormal Earnings Valuation as of Early Year 4

Calculations for Requirements 1 and 2
Cost of capital 9.0%
Initial book value 12/31/Year 3 $10,624
Dividend payout 40%
Forecasted ROCE on beginning equity 11.50%

Forecasted results (rounded to nearest $)

20X4 20X5 20X6 20X7 20X8 20X9 20X10 20X11 20X12 20X13
1 2 3 4 5 6 7 8 9 10

Forecasted earnings $1,222 $1,306 $1,396 $1,493 $1,595 $1,706 $1,823 $1,949 $2,084 $2,227

Beginning book value 10,624 11,357 12,141 12,978 13,874 14,831 15,855 16,949 18,118 19,368
+ Forecasted earnings 1,222 1,306 1,396 1,493 1,595 1,706 1,823 1,949 2,084 2,227
- Forecasted dividends -489 -522 -558 -597 -638 -682 -729 -780 -833 -891
Ending book value $11,357 $12,141 $12,978 $13,874 $14,831 $15,855 $16,949 $18,118 $19,368 $20,705

Forecasted earnings (from above) $1,222 $1,306 $1,396 $1,493 $1,595 $1,706 $1,823 $1,949 $2,084 $2,227
- Normal earnings -956 -1,022 -1,093 -1,168 -1,249 -1,335 -1,427 -1,525 -1,631 -1,743
Abnormal earnings 266 284 304 324 347 371 396 424 453 484
x Discount factor 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224
Present value of abnormal earnings 244 239 234 230 225 221 217 213 209 205

Initial book value $10,624

PV of abnormal earnings over 10 years 2,236
Estimated value of equity $12,860
Number of shares (millions) 307
Predicted share price $41.89
Abnormal Earnings Valuation as of Early Year 4
Calculations for Requirement 3
Cost of capital 9.0%
Initial book value 12/31/Year 3 $10,624
Dividend payout 40%
Forecasted ROCE on beginning equity 16.00%

Forecasted results (rounded to nearest $)

20X4 20X5 20X6 20X7 20X8 20X9 20X10 20X11 20X12 20X13
1 2 3 4 5 6 7 8 9 10

Forecasted earnings $1,700 $1,863 $2,042 $2,238 $2,453 $2,688 $2,946 $3,229 $3,539 $3,879

Beginning book value 10,624 11,644 12,762 13,987 15,330 16,801 18,414 20,182 22,119 24,243
+ Forecasted earnings 1,700 1,863 2,042 2,238 2,453 2,688 2,946 3,229 3,539 3,879
- Forecasted dividends -680 -745 -817 -895 -981 -1,075 -1,179 -1,292 -1,416 -1,552
Ending book value $11,644 $12,762 $13,987 $15,330 $16,801 $18,414 $20,182 $22,119 $24,243 $26,570

Forecasted earnings (from above) $1,700 $1,863 $2,042 $2,238 $2,453 $2,688 $2,946 $3,229 $3,539 $3,879
- Normal earnings -956 -1,048 -1,149 -1,259 -1,380 -1,512 -1,657 -1,816 -1,991 -2,182
Abnormal earnings 744 815 893 979 1,073 1,176 1,289 1,413 1,548 1,697
x Discount factor 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224
Present value of abnormal earnings 682 686 690 694 697 701 705 709 713 717

Initial book value $10,624

PV of abnormal earnings over 10 years 6,994
Estimated value of equity $17,618
Number of shares (millions) 307
Predicted share price $57.39