At the beginning of 2007 investors had invested $125,000 of common equity in Jets Corp.and expect to earn a return of 15% per year. In addition, investors expect Jets Corp. to pay out 100% of income in dividends each year. Forecasts of Jet's net income are as follows: 2007 - $41,000
2008 - $35,400
2009 - $33,200
2010 and beyond - $25,000
Using this information what is Jet's residual income valuation at the beginning of 2007?

Question

Quizplus · Accepted Answer

Residual income is calculated as the net income minus a required return on equity. The required return on equity is calculated as the equity investment multiplied by the expected return of 15%.

Required return on equity = $125,000 * 0.15 = $18,750

Residual income for each year is calculated as follows:

2007: $41,000 - $18,750 = $22,250
2008: $35,400 - $18,750 = $16,650
2009: $33,200 - $18,750 = $14,450
2010 and beyond: $25,000 - $18,750 = $6,250

The sum of these residual incomes is:

$22,250 + $16,650 + $14,450 + $6,250 = $59,600

Therefore, Jet's residual income valuation at the beginning of 2007 is:

$125,000 + $59,600 = $184,600

The correct answer is C.

At the Beginning of 2007 Investors Had Invested $125,000 of Common