As discussed in the chapter, abnormal earnings (AE) are

AE_t  =  X_t  −  (r_e  × BV_t−1)

where X_t is the firm’s net income, re is the cost of equity capital, and BV_t–1 is the book value of equity at t − 1.

Following are Xt, BVt–1, and re for two firms.

 

Required:

1. Calculate each firm’s AEt each year from 20X1 to 20X5.

2. Which firm was better managed over the 20X1–20X5 period? Why?

3. Which firm is likely to be the better stock investment in 20X6 and beyond? Why?

Company A 20X1 20X2 203 20X4 20X5 X BV $6,920 $79,632 $83,314 $89,920 $92,690 478,000 0.152 504,000 541,000 0.159 562,000 598,000 0.167 0. 172 0.166 Company B 20X1 20X2 203 20X4 20X5 X BV $192,940 877,000 0.188 $176,341 943,000 $227,700 989,999 0.183 $ 198,900 1,020,000 $ 282,964 1,199,000 0.179 0.175 0.186