CFA Practice Question

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CFA Practice Question

An analyst observes that the current book value per share for ABC Corp is $7.58, and its dividend payout is 100%. The return on equity for the firm is expected to remain constant. If current earnings were reported at $0.95, and the required rate of return on equity is 11%, which of the following would best estimate the present value of residual in come on a per share basis?

A. $1.06
B. $1.82
C. $8.63.
Correct Answer: A

Step 1. With a constant ROE and a zero retention rate, this company will have no earnings growth.

Step 2. Residual income = EPS - [(cost of equity)(Initial Book Value)] = $0.95 - [(.11)($7.58)] = $0.1162

Step 3. Present Value of Residual income (noting that it's a perpetuity): $0.1163/.11 = $1.06

User Contributed Comments 6

User Comment
shipping this seems very hard...
LloydBraun7 Other way:
Come up with the value of the stock: (next dividend)/(req. return)......since g = 0.
0.95/0.11 = 8.64.
This is the price per share.
Substract the book value per share (7.58).
You're left with residual value per share (1.06).
aravinda Any idea why the net book value (which is total asset = total debt + total equity) is used in the formula... I was under the impression that the netbook vlaue is the total asset not only equity...
Leese Thanks LloydBraun7, that's easier.
Allen88 aravinda, I think the book value is the equity value. Which is why the required rate of return on equity is charged against this value. Hope this helps.
davidt876 "book value per share" is understood to mean book value of equity. in the same way the market value of a company is understood to mean the market value of equity
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