of 76
An argument for using the residual income (RI) valuation approach is that residual income
valuation:
A) facilitates comparisons between divisions.
B) encourages company managers to maximize ROI.
C) reduces the problem of terminal value dominating total value.
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.