Question

Using the residual income valuation model, compute the price per share based on the following information:
- The book value per share is currently $18.00, and it is estimated to be $19.50 in one year from today and $21.00 in two years from now.
- The consensus of earnings per share for next year is $3.75, and it is $4.25 in two years from now.
- The residual income is forecasted to be zero in the third year and thereafter.
- Based on the CAPM, the required rate of return on the firm is 12%

Question 13 options:

	1) $19.24
	2) $20.94
	3) $21.16
	4) $22.05

Answer 1

Calculating the price of share using  residual income valuation model:

RIRI Vo = Bo +171+r) (1 + r)2

where, B₀ = Current Book value = $18

r = Required rate of return = 12%

RI₁ = Residual income at year end 1

RI₂ = Residual income at year end 2

- Computing Residual income of year end 1 & 2,

RI_t = EPS_t - (r*B_t-1)

RI₁ = 3.75 - (0.12*18) = 3.75 - 2.16 = 1.59

RI₂ = 4.25 - (0.12*19.5) = 4.25- 2.34 = 1.91

So, now calculating price per share:

1.59 1.91 Vo = 18 + 1 107(1+0.12)1 *(1 +0.12)2

Vo = 18 + 1.4196 +1.5226

Price per share = $ 20.94

Hence, Option 2

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