Question #27

Terminal value does not dominate total present value as is the case in dividend and free cash flow valuation models. Both remaining responses are arguments against using the RI approach. (Module 23.5, LOS 23.i) Jon Binkster, CFA, has decided to determine the value of the equity in Busicomb Inc. using the residual income method. Binkster has obtained financial statements for the year ended December 20x5. These financial statements are included in Exhibits 1–3 below. Exhibit 1 Busicomb Inc. Annual Income Statement For the Year Ended December 31, 20x5 (in $ millions) Sales 721.9 Operating expenses (417.0) Operating profit 304.9 Gain on sale of fixed assets 9.6 Depreciation (170.8) Earnings before interest and tax 143.7 Interest expense (40.3) Pre-tax income 103.4 Income taxes (31.0) Net income 72.4 Exhibit 2 Busicomb Inc. Balance Sheet As of December 31 (in $ millions) 20x5 20x4 Current Asset Cash and equivalents 31.2 14.0 Accounts receivable 72.0 64.8 Inventories 501.7 453.7 Total current assets 604.9 532.5 Non-Current Assets Property, plant, and equipment 1138.7 982.7 Less: Accumulated depreciation (370.0) (216.0) Net property, plant, and equipment 768.7 766.7 Total assets 1373.6 1299.2 Current Liabilities Accounts payable 60.1 62.5 Notes payable 30.0 20.0 Total current liabilities 90.1 82.5 Non-Current Liabilities Long term debt 576.0 588.0 Total liabilities 666.1 670.5 Shareholders' Equity Common equity 384.0 360.0 Retained earnings 323.5 268.7 Total equity 707.5 628.7 Total liabilities and equity 1373.6 1299.2 Exhibit 3 Busicomb Inc. Cash Flow Statement For the Year ended December 31, 20x5 (in $ millions) Cash Flow from Operating Activities Net income 72.4 Depreciation 170.8 Gain on sale of fixed assets (9.6) Change in Working Capital (Increase) Decrease in accounts receivable (7.2) (Increase) Decrease in inventories (48.0) Increase (Decrease) in accounts payable (2.4) Net change in working capital (57.6) Net cash from operating activities 176.0 Cash Flow from Investing Activities Purchase of property, plant, and equipment (183.2) Proceeds on disposal of plant and equipment 20.0 Net cash from investing activities (163.2) 12.8 Cash Flow from Financing Activities Change in debt outstanding (2.0) Change in common stock 24.0 Payment of cash dividend (17.6) Net cash from financing activities 4.4 Net change in cash and cash equivalents 17.2 Cash at beginning of period 14.0 Cash at end of period 31.2 You can assume for the following question that the ROE of Busicomb Inc. is 12% and the cost of equity is 13% and the long-term sustainable rate of growth is 7.5%. Binkster is concerned about the rate of growth he has assumed for the model and is aware that the residual income model can be used to calculate the implied rate of growth. He has compiled the following data for Entrebus Inc., a competitor, and wants to use this to calculate the implied rate of growth for Entrebus Inc.: The price to book ratio 2.50 ROE 13% Current book value per share $8.00 Cost of equity 11% Despite the issues encountered with post levered residual income Binkster is convinced that value based management approaches will prove beneficial in the analysis of Busicomb. His attention alights on another method referred to as Economic Value Added (EVA). Binkster makes the following estimates for Busicomb Inc. for 20x6: EBIT $150m Tax rate 30% Cost of equity 12% Cost of debt 7% The target debt to equity ratio for next year will be 1. The invested capital is to be calculated as long-term debt plus stockholders' equity (using the information from the Exhibits 1–3). Jon Binkster and a colleague, Bob Slacker, were discussing the merits of the residual income approach. Bob commented that the unrealized gains or losses relating to available for sale securities are reported in comprehensive income and not the income statement and that this results in earnings being an inaccurate measure of returns to investors. Bob states that the book value of equity is not affected. Binkster commented that including the gains or losses from one-off asset sales in income would distort the estimation of future residual earnings and therefore these gains and losses should be excluded. However, there is no need to adjust the book value of equity.