Professional Documents
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Equity investment
Residual Income Valuation
ng MS Excel
on
s sheet:
using the two and multiple periods residual income
ffered by Pristine.
Question
Randy Harper, CFA and Robert Cooper are co-managers of General Public Fund. The fund contains
Both of them are highly competitive and try not to leave even a single chance to let other person
the fund as they try to outperform each other.
Portfolio managed by Randy comprises of Veron Ltd, a telecom player of US market. As per the re
financial year. Currently, shares are trading at a price of $34 and number of outstanding shares is
and market value of the debt is same as its book value. As per the analyst, the replacement cost
Ultra Ltd, an electric utilities company based in US, is managed by Robert. Its required rate of ret
ratio of 75%.
Cloda Motors, managed by Randy, has a current book value of $6.5 per share and dividend payou
the next five years. The required rate of return is 11%. As per Randys expectations, after 5 years
with a persistence factor of 0.3. However, Robert had different views which he expressed in the re
long-run average level and the price-to-book ratio will approach 1.5.
Randy didnt like the way Robert responded. In order to get back to him, he challenged the valua
the residual income model. Randy claimed that inventory has been valued using LIFO while as pe
he should have taken LIFO reserve into consideration while making suitable adjustments.
Realizing that situation could go out of proportion, senior management took the charge and warn
behaviour. In the same meeting, Michael Wayne, a new recruit, presented his updates for the firs
Statement 1:
I plan to adopt DDM for valuing market indices
Statement 2:
I plan to adopt residual income model for the firms which hold clean surplus relation and have vo
Q1. Based on the data given, Tobin's Q for Veron Ltd is closest to:
Options
A.
1.11
B.
1.09
C.
0.57
Q2. Based on the fundamentals given, Ultra Ltd's justified P/B is closest to:
Options
A.
2
B.
2.67
C.
3
Q3. Based on multistage residual income model, intrinsic value of Cloda Motors, using Randy's esti
Options
A.
$8.33
B.
$7.97
C.
$8.08
Q4. Change in intrinsic value of Cloda Motors, using Robert's estimate of persistence factor and P/B
Options
A.
Increase by $2.81
B.
Increase by $3.17
C.
Increase by $3.11
Q5. Assuming positive change in LIFO reserve, impact of LIFO reserve adjustments on residual inco
Options
A.
ROE and intrinsic value will increase
B.
Book value and intrinsic value will increase
C.
ROE, book value and intrinsic value will increase
Q6. Out of the two statements made by Michael, he was correct with respect to:
Options
A.
Statement 1
B.
Statement 2
C.
Both statement 1 and 2
Fund. The fund contains securities in the telecommunication, power and auto sectors.
ance to let other person down. However, this competitive rivalry has so far benefitted
S market. As per the reports, book value of the equity stood $880 million, last
of outstanding shares is 25 million. Company has a debt of $790 million on its book
, the replacement cost of assets for Veron Ltd would be $1.5 billion.
Its required rate of return is 10% and ROE is 16%. Company has a dividend payout
are and dividend payout ratio of 30%. It is expected to maintain an ROE of 16% over
ectations, after 5 years, Clodas residual income will decline over the time to zero
h he expressed in the review meeting. He expected that Clodas ROE will fall to a
e challenged the valuation of Nadinto Ltd, held by Robert. It was valued at $65 using
d using LIFO while as per the standards FIFO method should have been adopted. So,
e adjustments.
ok the charge and warned both of them from indulging into such inappropriate
his updates for the first time. He made following statements
rsistence factor and P/B ratio as compared to Randy's estimate, is closest to:
Veron Ltd
Book value of equity ($ million)
BE
BD
MD
RC
N
P0
Ultra Ltd
Required return on equity
Expected return on equity
Dividend payout ratio
r
ROE
1-b
Cloda Motors
Current book value per share ($)
Dividend payout ratio
Expected return on equity
Duration of high-growth period (yrs)
Required return on equity
Persistence factor (Randy's estimate)
Expected P/B ratio, after 5 years (Robert's estimate)
B0
1-b
ROE
T
r
w
P5/B5
880
790
790
1500
25
34
10%
16%
75%
6.5
30%
16%
5
11%
0.3
1.5
Ans 1:
Market value of equity ($ million)
Tobin's Q
Correct Option
N * P0
(ME + MD)/RC
Ans 2:
Retention Ratio (b)
Growth rate
b * ROE
(ROE - g)/(r - g)
Correct Option
Ans 3:
Cloda Motors Residual Income Forecast
Year
0
1
2
3
4
5
16%
16%
16%
16%
16%
Intrinsic Value
Correct Option
ROE
11%
RI5/(1+r-w)
Ans 4:
Required return on equity
11%
Intrinsic Value
(P5 B5 +RI5)/(1+r)
3.17
Ans 6:
Correct Option
P5/B5 * B5
Ans 5:
Correct Option
11.05
Under
Under LIFO
LIFO adjustment,
adjustment, LIFO
LIFO rese
res
aa result,
both
earnings
and
book
result, both earnings and book
Both
Both statements
statements are
are correct
correct with
with res
re
`
850
1.09
0.25
4%
2.0
Et
Dividend Payout
1.04
1.16
1.29
1.43
1.59
30%
30%
30%
30%
30%
Dt
0.31
0.35
0.39
0.43
0.48
0.61
=
8.08
6.5
7.23
8.04
8.94
9.94
11.05
0.72
0.80
0.88
0.98
1.09
P5 B5 +RI5)/(1+r)
16.58
=
5.43
=
11.25
adjustment,
adjustment, LIFO
LIFO reserve
reserve will
will be
be added
added to
to invested
invested capital
capital and
and change
change in
in LIFO
LIFO reserve
reserve will
will be
be added
adde
th
earnings
and
book
value
will
increase
thereby
leading
to
increase
in
intrinsic
value.
th earnings and book value will increase thereby leading to increase in intrinsic value.
ents
ents are
are correct
correct with
with respect
respect to
to the
the implementation
implementation of
of valuation
valuation models.
models.
serve will
eserve
will be
be added
added to
to NOPAT.
NOPAT. As
As
alue.
value.