Determining abnormal earnings-Some examples (LO6-1)

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

AE_t = X_t (r_e BV_t1)

where X_t is the firms 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?