Determining abnormal earnings-Some examples (LO6-1)

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, r _e is the cost of equity capital, and BV _t-1 is the book value of equity at time t − 1.

Required:

Solve the following problems: (Negative amounts for any of your answers should be indicated by a minus sign.)

If X _t is $5,000, r _e = 15%, and BV _t-1 is $50,000, what is AE _t ?

If X _t is $25,000, r _e = 18%, and BV _t-1 is $125,000, what is AE _t ?

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

Assume the firm in requirement 2 can divest $25,000 of unproductive capital with X _t falling by only $2,000. What is the new AE _t ?

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

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

1. AEt

2. AEt

3. AEt

4. AEt

5. Would adding the new division increase AEt?

6. Would adding the new division increase AEt?