At the beginning of 2012 investors had invested $125,000 of common equity in Jan Corp. and expect to earn a return of 15% per year. In addition, investors expect Jan Corp. to pay out 100% of income in dividends each year. Forecasts of Jan's net income are as follows:
2012 - $41,000
2013 - $35,400
2014 - $33,200
2015 and beyond - $25,000
Using this information, what is Jan's residual income valuation at the beginning of 2012?

Question

Quizplus · Accepted Answer

Residual income is calculated as net income minus a capital charge, where the capital charge is the required return on the investors' equity investment.

First, we need to calculate the required return on the investors' equity investment:
$125,000 * 15% = $18,750 per year

Next, we need to calculate the capital charge for each year by subtracting the required return from the net income:
2012: $41,000 - $18,750 = $22,250
2013: $35,400 - $18,750 = $16,650
2014: $33,200 - $18,750 = $14,450
2015 and beyond: $25,000 - $18,750 = $6,250

We only need to calculate the residual income for 2012, since that's the year of the initial investment. The residual income is the capital charge for 2012:
Residual income = $22,250

Therefore, the residual income valuation at the beginning of 2012 is $190,262 ($125,000 initial investment + $22,250 residual income for 2012 multiplied by the present value factor for a perpetuity at 15%, which is 1/0.15 = 6.6667).

At the Beginning of 2012 Investors Had Invested $125,000 of Common