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Question: Beagle Beauties engages in the development, manufacture, and sale of a line of cosmetics designed...

Beagle Beauties engages in the development, manufacture, and sale of a line of cosmetics designed to make your dog look glamorous. Below you will find selected information necessary to compute some valuation estimates for the firm. Assume the values provided are from year-end 2015. Also assume that the firm’s equity beta is 1.40, the risk-free rate is 2.65 percent, and the market risk premium is 7.4 percent.

Dividends per share	$	3.72
Return on equity		14.50	%
Book value per share	$	17.75

	Earnings			Cash Flow			Sales
2015 value per share	$	6.40		$	7.30		$	26.35
Average price multiple		14.50			9.84			2.92
Forecasted growth rate		13.76	%		12.11	%		8.18	%

The required return is 13.01 percent. Use the clean surplus relationship to calculate the share price for Beagle Beauties with the residual income model. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

	Share price

Answer 1

Lets first understand what is residual income model - It is a method for stock valuation which accounts for the cost of equity capital. Residual income (RI) is calculated as RI = PAT - Equity Charge (BV*Ke). The word ‘residual’ mean in excess of any opportunity costs measured relative to the book value and the income that a firm generates after accounting for the true cost of capital is then the residual income. This approach is very much resemble to the Economic Value Added approach which also having similar kind of logic.

Information given

DPS - 2015

3.72

EPS - 2015

6.40

Div. Payout - 2015

58.13%

RoE

14.50%

BVPS - 2015

17.50

EPS gr

13.76%

Ke

13.01%

Solution:

Step 1. Calculare Equity Charge (per share):

Equity Charge (per share) = Book Value (per share) x Cost of Equity%

Equity Charge (per share) = 17.5*13.01% =

2.28

Step 2. Residual Income (per share) in Year 2016

Residual Income in 2016 =

EPS 2016 - Equity Charge

2015 EPS

6.40

2016 EPS (expected)

7.28

(6.4*1.1376)

Residual Income in 2016 =

5.00

(7.28-2.28)

Step 3. Residual Income constant growth rate

As this is a single state RI valuation model so we have to calculate Sustainable Growth Rate (SGR)

Formula = RoE% * (1-dividend payout ratio)

SGR =

6.07%

Step 4. Residual Income valuation = BVPSo + RIt/(Ke-SGR)

The estimated value equals the current BVPS + present value of future expected residual income (which here can be valued as a perpetuity):

Value per share (VPS)= BVPS + PV of expected future Residual Income (per share)

PV of expected future Residual Income (per share) = Residual Income in 2006 / (Ke-SGR)

VPS =

89.55

17.5 + 5/(0.1301-0.0607)