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

A E t = X t ( r e B V t1 )

where Xt is the firms net income, re is the cost of equity capital, and BVt1 is the book value of equity at time t

1. Required: Solve the following problems:

1. If Xt is $5,000, re = 15%, and BVt1 is $50,000, what is AEt?

2. If Xt is $25,000, re = 18%, and BVt1 is $125,000, what is AEt?

3. Assume the firm in requirement 2 can increase Xt to $30,000 by instituting some cost-cutting measures. What is the new AEt?

4. Assume the firm in requirement 2 can divest $25,000 of unproductive capital with Xt fall-ing by only $2,000. What is the new AEt? .

5. Assume the firm in requirement 2 can add a new division at a cost of $40,000, which will increase Xt by $7,600 per year. Would adding the new division increase AEt?

6. Assume the firm in requirement 1 can add a new division at a cost of $25,000, which will increase Xt by $3,500 per year. Would adding the new division increase AEt?