Deck 13: Valuation: Earnings-Based Approaches

Question 1

Assume that a firm's book value at the beginning of the year is $12,500 and that the firm reports net income of $3,200 and pays dividends of $1,100_. What will the firm's book value at the end of the year?

A) $2,100
B) $15,700
C) $14,600
D) $16,800

Answer 1

C

Question 2

The appropriate discount rate for the residual income model is

A) Weighted average cost of capital
B) The risk free interest rate
C) The risk free interest rate plus the market premium
D) Cost of common equity capital

Answer 2

D

Question 3

Required earnings are the

A) adjusted net income multiplied by the required rate of return on common equity capital.
B) net income the analyst expects the firm to generate multiplied by the required rate of return on common equity capital.
C) the market value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.
D) the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.

Answer 3

D

Question 4

Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,600 at the end of 2005. During 2006 the firm earns net income of $1,300, pays dividends to shareholders of $600, and uses $300 to repurchase common shares. The book value of shareholders equity at the end of 2006 is:

A) $2,000
B) $400
C) $3,800
D) $2,600

Question 5

At the beginning of 2007 investors had invested $25,000 of common equity in Giants Corp.and expect to earn a return of 11% per year. In addition, investors expect Giant Corp. to pay out 100% of income in dividends each year. Forecasts of Giant's net income are as follows: 2007 - $3,500
2008 - $3,200
2009 - $2,900
2010 and beyond - $2,750
Using this information what is Giant's residual income valuation at the beginning of 2007?

A) $25,000
B) $26,350
C) $26,151
D) $26041

Question 6

The ______________________________ valuation model uses expected future net income and the book value of common shareholders' equity as the basis for valuation.

Question 7

Jones Corp. Use this information to answer the following questions:
At the end of 2005 Jones Corp. developed the following forecasts of net income:
Management believes that after 2010 Jones will grow at a rate of 7% each year. Total common shareholders' was $112,768 on December 31, 2005. Jones has not established a dividend and does not plan on paying dividends during 2006 to 2010, its cost of equity capital is 12%.
What would be Jones' common shareholders' equity at the end of 2009?

A) $180,909
B) $208,161
C) $95,540
D) $112,768

Question 8

If investors have invested $25,000 of common equity in a company and it is determined that the required earnings of the company are $2,250 each period, then investors must expect to earn what return?

A) the risk free rate
B) 9%
C) 11%
D) the market premium

Question 9

Residual income valuation focuses on ____________________ as a periodic measure of shareholder wealth creation.

Question 10

The value of a share of common equity should equal the present value of the _____________________________________________ the shareholders will receive.

Question 11

Residual income valuation focuses on

A) dividend-paying capacity in free-cash flows.
B) earnings as a periodic measure of shareholder wealth creation.
C) free cash flows as a periodic measure of shareholder wealth creation.
D) dividends as a periodic measure of shareholder wealth creation.

Question 12

Jones Corp. Use this information to answer the following questions:
At the end of 2005 Jones Corp. developed the following forecasts of net income:
Management believes that after 2010 Jones will grow at a rate of 7% each year. Total common shareholders' was $112,768 on December 31, 2005. Jones has not established a dividend and does not plan on paying dividends during 2006 to 2010, its cost of equity capital is 12%.
Compute the value of Jones Corp. on January 1, 2006, using the residual income valuation model. Use the half-year adjustment.

A) $112,768
B) $185,329
C) $195,540
D) $133,624

Question 13

Residual income will be zero when

A) the firm's reported net income exactly equals the required level of earnings necessary to cover the cost of equity capital.
B) the firm's expected future income is greater than the required level of earnings necessary to cover the cost of equity capital.
C) the firm's expected future income exactly equals the required level of earnings necessary to cover the cost of equity capital.
D) the firm's expected future income is less than the required level of earnings necessary to cover the cost of equity capital.

Question 14

Assume that a firm's book value at the beginning of the year is $17,800 and that the firm reports net income of $6,200. If the firm's book value at the end of the year is $20,000 what was the amount of dividends paid during the year?

A) $4,000
B) $8,800
C) $2,200
D) Insufficient information to determine

Question 15

If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be

A) exactly equal to the book value of common shareholders' equity.
B) greater than the book value of common shareholders' equity.
C) less than the book value of common shareholders' equity.
D) exactly equal to working capital.

Question 16

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?

A) $125,000
B) $184,600
C) $190,262
D) $260,415

Question 17

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect

A) the dividend paying ability of the firm.
B) the free cash flows available to shareholders.
C) the value of the firm to shareholders.
D) the value of the firm for debtholders and shareholders.

Question 18

Jones Corp. Use this information to answer the following questions:
At the end of 2005 Jones Corp. developed the following forecasts of net income:
Management believes that after 2010 Jones will grow at a rate of 7% each year. Total common shareholders' was $112,768 on December 31, 2005. Jones has not established a dividend and does not plan on paying dividends during 2006 to 2010, its cost of equity capital is 12%.
What would be Jones' residual income in 2008?

A) $24,552
B) $18,763
C) $5,789
D) $5,200

Question 19

Residual income is

A) adjusted net income the firm reports.
B) the difference between the net income the analyst expects the firm to generate and the required earnings of the firm.
C) the difference between the net income the analyst expects the firm to generate and the reported earnings of the firm.
D) the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.

Question 20

Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,200 at the end of 2005. During 2006 the firm earns net income of $900, pays dividends to shareholders of $400, and issues new stock to raise $250 of capital. The book value of shareholders equity at the end of 2006 is:

A) $2,750
B) $250
C) $1,450
D) $1,950

Question 21

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect the ______________________________ to the shareholders.

Question 22

What are the three arguments economists provide against using earnings as a value-relevant attribute in valuation?

Question 23

When debating the issue of whether to use free cash flows or earnings in a valuation model economists sometimes argue that ____________________ can be subject to purposeful management by a firm and thus make them less useful.

Question 24

Over the life of the firm, the present value of ______________________________, ______________________________, and ____________________ will be the same.

Question 25

Clean surplus accounting means that ____________________ include all direct capital transactions between the firm and the common equity shareholders.

Question 26

Over sufficiently long periods, _________________________ equals free cash flows to common equity.

Question 27

If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be equal to the ______________________________ of common shareholders' equity.

Question 28

Clean surplus accounting means that net income includes all of the recognized elements of income for the firm for _____________________________________________.

Question 29

Economists sometimes argue that earnings are not a _________________________ attribute on which to base valuation.

Question 30

Provide the intuition for the residual income valuation model. In addition, define residual income.

Question 31

Accounting for the book value of common shareholders' equity in a firm can be expressed as follows:
BV_t = BV_t-1 + ____________________ - D_t.

Question 32

The required earnings of the firm equals the product of the required rate of return on common equity capital times the __________________________________________________ at the beginning of the period.

Question 33

______________________________ is the amount by which expected future earnings exceed the required earnings.

Question 34

Accounting earnings numbers provide a basis for valuation because earnings are the primary measure of ______________________________ produced by the accrual accounting system.

Question 35

____________________ are the fundamental, value-relevant attribute of expected future returns.

Question 36

The foundation for residual income valuation is the classical _____________________________________________.

Question 37

The residual income valuation approach assumes that accounting for net income and book value of shareholders' equity follows ________________________________________.

Question 38

What is the rationale for using expected earnings as a basis for valuations?

Question 39

Accounting principles make accrual accounting earnings closer to the firm's underlying economic performance in a given period than are _________________________.

Question 40

What is meant by the term clean surplus accounting?

Question 41

Investors have invested $25,000 in common equity in a company. Given the risk inherent in the company the investors expect to earn a 15 percent return. In addition, the investors expect that the company will reinvest all income in projects that will earn 16%. The company is forecasted to earn $6,000 the first year, $5,000 the second year, $5,500 the third year and $6,244 each year after the third year. For this company determine the company's residual income valuation (round all numbers to the nearest dollar).

Question 42

Investors have invested $25,000 in common equity in a company. Given the risk inherent in the company the investors expect to earn a 15 percent return. In addition, the investors expect the company to return all income to investors in the form of dividends. The company is forecasted to earn $4,000 the first year, $5,000 the second year, $4,500 the third year and $3,750 each year after the third year. For this company determine the company's residual income valuation

Question 43

Currently U.S. GAAP does not follow clean surplus accounting, what are the four dirty surplus items that do not flow through net income?

Question 44

Builder, Inc. is a distributor of tools and building supplies. Management for the company has developed the following forecasts of net income:
Management expects net income to grow at a rate of 7 percent per year after 2010 and the company's cost of equity capital is 14%. Management has set a dividend payout ratio equal to 25% of net income and plans to continue this policy. Builder's common shareholders' equity at January 1, 2006 is $544,902.
Required:

Question 45

Why is the weighted average cost of capital not used as the discount rate when computing residual income?

Question 46

Power, Inc. is a distributor of electrical supplies and tools. Management for the company has developed the following forecasts of net income:
Red Ranger, CFO of Power, Inc. expects net income to grow at a rate of 9 percent per year after 2011 and the company's cost of equity capital is 15%. Management plans to payout all income in dividends and plans to continue this policy into the future. Power's common shareholders' equity at January 1, 2006 is $100,000.
Required:

Question 47

Investors have invested $25,000 in common equity in a company. Given the risk inherent in the company the investors expect to earn a 15 percent return. In addition, the investors expect the company to return all income to investors in the form of dividends. The company earns $4,000 the first year. For this company determine the following: