11. Use the same facts as Question 8, except derive the value of the company and the price per common share using the earnings-based valuation model.

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. Compare your answer to the answer you got using the free cash flow to equity investors (dividend discount model) in Question 4.

*Question 8*

Assume you expect a company's net income to remain stable at $2000 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (this also assumes a clean surplus). Also, assume the company's ? = 1.2, the market risk premium is 6% and the 10-year yield on risk-free government bonds is 3%. Finally, assume the company has 1000 ordinary shares outstanding.

*Question 4*

Calculate the proportion of terminal values to total estimated values of equity under the abnormal earnings method and the discounted cash flow method for the Scenario 2 results shown in Figure 8.7. Why are these proportions different?

Abnormal earnings value Terminal Terminal beyond the forecast Scenario Approach Scenario sales growth NOPAT margin horizon ($000s) Persistent abnormal Sales growth and margins based 3.0% 8.0% 335 583 earnings performance on detailed analysis and forecast 2 Abnormal returns on Sales grow at the rate of inflation, 2.1% 8.0% 271 676 constant sales (real terms) margins maintained Abnormal returns on Essentially zero sales growth, 0.0% 8.0% 186 376 constant sales (nominal margins maintained terms) 4 Competitive equilibrium Margins reduced so no abnormal 3.0% 5.19% O earnings