Question

Annabel Temitope is evaluating the expected residual income as of the end of September 20X4 for Asia Pulp and Paper Company (PAP), a vertically-integrated pulp and paper producer. Using an adjusted beta of 1.20 relative to the S&P 500 Index, a 10-year government bond yield of 1.70%, and an estimated equity risk premium of 3.80%, Temitope uses the capital asset pricing model (CAPM) to estimate PAP’s required rate of return. Temitope obtains the following as of the close of September 20X4.

Exhibit 1. Asia Pulp and Paper Company

Current market price	$11.90
Book value per share as of 31 December 20X3	$9.96
Consensus annual earnings estimates
FY 20X4	$3.52
FY 20X5	$3.64
Annualized dividend per share forecast
FY 20X4	$1.46
FY 20X5	$1.55

David Emmanuel, Temitope’s supervisor, has reviewed her computations on the expected residual value income for PAP. He has calculated the stock value of PAP and would like Temitope to do the same. They use different approaches but perform the calculations using consistent assumptions.

• Emmanuel’s approach: calculate the stock value using the residual income model.
• Temitope’s approach: calculate the stock value using the dividend discount model instead.

Cynthia Promise, a co-worker of Temitope, specializes in the airline industry. Recently she has been monitoring Southwest Airlines (NYSE: LUV). She considers a stock to be fairly valued if her intrinsic value calculation using the single-stage residual income model is within 10% of the current market price. She has gathered the following information for LUV:

• Current book value per share = $26
• Current market price per share = $44
• Assumed long-term ROE is 11% and long-term growth is 5.5%
• The cost of equity based on the Capital Asset Pricing Model is 8.5%

Emmanuel asks Temitope and Promise to create a list of strengths and weaknesses of residual income models. They worked together and submitted the following list to Emmanuel.

Strength 1: The models focus on economic profitability.
Strength 2: The cost of debt capital is reflected appropriately by interest expense.

Weakness 1: The models do not work well when cash flows are unpredictable.
Weakness 2: Accounting data used as inputs may require significant adjustments.

Emmanuel reviews the list created by Temitope and Promise and makes the following two statements:

Statement 1: The residual income model is most appropriate when a company’s dividends are not predictable.
Statement 2: The residual income model is least appropriate if the book value is not predictable.

Question

Based on the information provided in Exhibit 1, what is the forecast ending book value per share for FY 20X4?

Question

Based on the information in exhibit 1, what is the forecast residual income for fiscal year 20X5 that Temitope would calculate?

Question

Based on a residual income model, what is LUV’s value per share Promise would calculate? And is LUV’s share overvalued, undervalued, or fairly valued?

Short-Answer Questions: (Please explain/justify your answer)

Question

Which of the strength and weakness listed by Temitope and Promise is(are) incorrect?

Question

Which of Emmanuel's statements about the appropriateness of the residual income model is accurate?

Answer 1

Ans- A) book value for end 2014 = 12.02

- Book value(2014)= Book value(2013)+ Eps(2014)  - Dividend(014) .

- Book Value(2014) = 9.96 + 3.52 -1.46 = 12.02.

B) 2.978

- forecasted residual income 2015 = EPS(2015) - ( rate of return x book value(2014)). Rate of return = 10 year US bond yield + equity premium = .0170 + .0380 = 0.055

- Forcasted residual income 2015 = 3.64 - (0.055 x 12.02) = 2.978.

C) Stock value by residual income= 48.75 and stock is fairly price.

- The residual income of LUV = (ROE - rate of return ) x book value(current).

- Residual income = (0.11 - 0.085) x 26 = 0.65

- value of stock using one stage residual income model = BV(t) + [ Residual income x (1+ growth) / (Ke - growth)].

- LUV stock value= 26 + [0.65 x(1+0.055 ) / (0.085 - 0.055)] = 48.75.

- Stock is fairly price as residual stock value is under the 10% of current stock price (i.e 44 x(1.10) = 48.5)

D) strength 2 and weakness 1 is incorrect as-,

- Strength 2 = For calculation of residual income we don't need cost of debt rather it is used in valuation of free cashflow and other methods. Therefore it is not the strength of residual income model it can been seen in formula itself that we don't require cost of debt for valuation through residual income.

- Weakness 1= when the cashflow is unpredictable than it is best to use residual model as for valuation through residual income we don't need to calculate free cashflow, therefore, it is a strength of residual method that it don't require calculation of free cashflow.