Computing Residual Income. Suppose the following hypothetical data represent total assets, book value, and market value of
Question:
Computing Residual Income. Suppose the following hypothetical data represent total assets, book value, and market value of common shareholders’ equity (dollar amounts in millions) for three firms. Each of these firms, Southwest Airlines, Kroger, and Yum! Brands, operates in a different industry, but all of them operate in very competitive industries. Southwest Airlines is a U.S. domestic airline that provides low-cost point-to-point air transportation services. Kroger operates retail supermarkets across the United States. Yum! Brands operates and franchises quick-service restaurants, including KFC, Pizza Hut, Taco Bell, Long John Silver’s, and A&W All American Food restaurants. These data also include hypothetical market betas for the three firms and analysts’ consensus forecasts of net income for Year +1. For each firm, analysts expect other comprehensive income items for Year +1 to be zero; so Year +1 net income and comprehensive income will be identical. Assume that the risk-free rate of return in the economy is 4.0% and the market risk premium is 5.0%.
REQUIRED
a. Using the CAPM, compute the required rate of return on equity capital for each firm.
b. Project required income for Year þ1 for each firm.
c. Project residual income for Year þ1 for each firm.
d. Rank the three firms using expected residual income for Year þ1 relative to book value of common equity.
e. What do the different amounts of residual income imply about each firm? Do the projected residual income amounts help explain the differences in market value of equity across these three firms? Explain.
Expert Answer:
