Question #65
Reading: Reading 23 Residual Income Valuation
PDF File: Reading 23 Residual Income Valuation.pdf
Page: 31
Status: Unattempted
Question
Creative Gardening is expected to have a return on equity (ROE) of 13% for the next five years and slightly lower thereafter. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $7.50 per share and its required rate of return is 10%. The premium over book value at the end of five years is expected to be 30%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $1.10. The projected ending book value in year 5 is $13.83. What is the value of Creative Gardening using these inputs?
Answer Choices:
A. $11.18
B. $13.83
Explanation
Applying the residual income valuation model:
V0 = B0 + sum of discounted RIs + discounted premium
= 7.50 + 1.10 + [(0.30)(13.83)/(1.10)5] = $11.18