At the beginning of its fiscal year 2020, an analyst made the following forecast for ABC,...

At the beginning of its fiscal year 2020, an analyst made the following forecast for ABC, Inc. (in millions of dollars):

	2019	2020	2021	2022	2023	2024
Earnings		320	350	245	321	220
Dividends		150	120	98	105	86
Book value	890

Suppose these numbers were given to you at the end of 2019, as forecasts, when the book value was 890 million, as indicated and market price of the stock was $10.5 per share. Use a required return of 10 percent for calculations below. Show your working process.

Calculate residual earnings and return of common equity (ROCE) for each year, 2020–2024.

[5 marks]

Value the firm at the end of 2019 under the assumption that the RE in 2024 will continue at the same level subsequently.

[2 marks]

Based on you analysis, if the number of shares outstanding at the end of 2019 was 220 million, what should be the share price of ABC?

[1 mark]

Based on your estimate, should investors buy the share of this company?

[1 mark]

Expert Solution


Information

Book Value ($)	890 million
ROR	10%
Market Price	10.5
Capital charge (890*10%)	$ 89 M

Answer to part (i)

Residual Earnings		($ million)
	Year	Earnings (PAT)	Capital Charge	Residual Earnings
	2020	320	89	231
	2021	350	89	261
	2022	245	89	156
	2023	321	89	232
	2024	220	89	131

ROCE		($ million)
	Year	Earnings (PAT)	Common Equity	ROCE (%)
	2020	320	890	35.96%
	2021	350	890	39.33%
	2022	245	890	27.53%
	2023	321	890	36.07%
	2024	220	890	24.72%

Answer to part (ii)
	Year	Particulars	Amount ($ million)	PV factor @ 10%	PV
	2020	RE (earning-div)	170	0.909	154.55
	2021	RE (earning-div)	230	0.826	190.08
	2022	RE (earning-div)	147	0.751	110.44
	2023	RE (earning-div)	216	0.683	147.53
	2024	RE (earning-div)	134	0.621	83.20
	2024	Market Value	= 134/10% = $ 1340	0.621	832.03
	Value of firm at the end of 2019	$ 1,517.84	million


Answer to part (iii)
	If shares outstanding 220 Million, share price of ABC should be 1517.84/220 = $ 6.899 = $ 6.90/share approx.


Answer to part (iv)

	As share is trading at $ 10.5/share i.e trading rich, so investor should not be purchased the share

ekkarill92 answered 2 years ago

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