Question

The following is extracted from the income statement and balance sheet of a firm for 2017. (Amounts in $ thousands) Operating income (after tax) 17,507 Net financial expenses 3,060 Comprehensive income 14,447 The firm paid out all income in dividends at the end of the year and there were no share issues during 2017. The book value of common equity at the end of 2017 was $100,600. The cost of equity capital is 11%. (a) Calculate residual income for 2017. (b) The residual income for 2018 and all subsequent years is expected to be the same as in 2017. Calculate the value of the equity at the end of 2017.

Answer 1

Solution:

Part a --- Residual Income for 2017

Residual Income measures net income after taking into account all required cost of capital related to generating that income. The Residual Income also known as Economic Value Added.

Residual Income = Net Income from Operation (We can find out this from Income Statement) – (Book Value of Common Equity x Cost of Equity Capital)

= $17,507 – ($100,600*11%)

= $17,507 - $11,066

= $6,441

Part b – Value of the equity at the end of 2017

Value of Equity at the end of 2017 (using residual income approach) = Book Value of Common Equity at the end of Year 2017 + Present Value of its expected future residual incomes

Here,

Book Value of Common Equity at the end of Year 2017 (given) = $100,600

Present Value of its expected future residual incomes = Residual Income $6,441 / Cost of Equity 11%

= $58,554.55

Therefore,

Value of Equity at the end of 2017 (using residual income approach) = $100,600 Book Value of Common Equity at the end of Year 2017 + Present Value of its expected future residual incomes $58,554.55

= $159,154.55

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