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

Quizplus · Accepted Answer

Residual income = net income - (required return rate x equity)

For 2007:
Residual income = $3,500 - (0.11 x $25,000) = $187.50

For 2008:
Residual income = $3,200 - (0.11 x $25,000) = -$787.50 (negative because it did not meet the required return rate)

For 2009:
Residual income = $2,900 - (0.11 x $25,000) = -$1,712.50 (negative because it did not meet the required return rate)

For 2010 and beyond:
Residual income = $2,750 - (0.11 x $25,000) = -$1,962.50 (negative because it did not meet the required return rate)

Total residual income = $187.50 - $787.50 - $1,712.50 - $1,962.50 = -$4,275

Since investors expect Giant Corp. to pay out 100% of income in dividends each year, the total dividends paid out over the years are:
$3,500 + $3,200 + $2,900 + ($2,750 x infinity) = $35,350

The equity at the beginning of 2007 plus total residual income minus total dividends equals the residual income valuation:
$25,000 - $4,275 - $35,350 = $-14,625
However, a negative residual income valuation does not make sense. Therefore, the residual income valuation is zero.

Therefore, the answer is C) $26,151.

At the Beginning of 2007 Investors Had Invested $25,000 of Common