Question

Nathan Tan valuing the Doral Corporation determines that the book value is $10.50 and the stock is trading at $14.00. Nathan estimates that Doral will earn an ROE of 20 percent over the next three years. The company is expected to payout 40 percent of earnings during this period. At the end of three years, the stock is expected to trade at two times the company’s book value. The required return is 14 percent. The residual income for Doral (to the nearest $0.01) at the end of next year is:

$0.71

$0.60

None of the listed choices is correct.

$0.79

$0.63

Answer 1

P3 = Book value * 2

     = 10.50 * 2

     = $ 21

Growth = Return on equity * retention ratio

           = 20% * ( 1 - 0.40 )

          = 0.12

P0 = D1 / ( 1 + r ) + D2 / ( 1 + r )² + D3 / ( 1 + r )³ + P3 / ( 1 + r )³

P0 = D0 * ( 1 + g ) / ( 1 + r ) + D0 * ( 1 + g )² / ( 1 + r )² + D0 * ( 1 + g )³ / ( 1 + r )³ + P3 / ( 1 + r )³

P0 = [ ( EPS * 0.40 ) * ( 1 + g ) / ( 1 + r ) ] + [ ( EPS * 0.40 ) * ( 1 + g )² ] / ( 1 + r )²   + [ ( EPS * 0.40 ) * ( 1 + g )³ / ( 1 + r )³ ] + [ P3 / ( 1 + r )³ ]

P0 = EPS * [ 0.40 * ( 1 + g ) / ( 1 + r ) ] + [ 0.40 * ( 1 + g )² ] / ( 1 + r )²   + [ 0.40 * ( 1 + g )³ / ( 1 + r )³ ] + [ P3 / ( 1 + r )³ ]

14 = EPS * [ 0.40 * ( 1 + 0.12 ) / ( 1 + 0.14 ) ] + [ 0.40 * ( 1 + 0.12 )² ] / ( 1 + 0.14 )²   + [ 0.40 * ( 1 + 0.12 )³ / ( 1 + 0.14 )³ ] + [ 21 / ( 1 + 0.14 )³ ]

14 = EPS * [ 0.393 + 0.386 + 0.3793 + 14.17 ]

14 = EPS * 15.3283

EPS = 14 / 15.32830

EPS = $ 0.9133 Answer