Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

hAs decribed in the chapter, the abnormal earnings approach for estimating commob share value is P 0 = BV 0 + sum _ {

hAs decribed in the chapter, the abnormal earnings approach for estimating commob share value is P0=BV0+\sum_{t=1}^{\infty }{E_{0}(x_{1}-r\times BV_{t-1}})/{(1+r)^{t}}where P0is the total of all outstanding shares. BV0 is the current bookfolders' equity, BVt-1 is the book value of shareholders equity in the beginning of the period t, r is the cost of equity capitol, E0 is the exceptions operator, and X1 is period t net income. The model says that share value equals the book value of stockholders' equity plus the present value of future expected abnormal earnings (where abnormal earnings is the net income minus the cost of equity capital multiplied by the beginning of period book value of stockholders equity. The model is silent on how one comes up with expected net income for future years (and therefore future expected abnormal earnings) and just how many future years should be used. Because of the way present value is calculated, abnormal earnings amounts expected for years in the distant future have small present value and are essesntially irrelevant to valuation, especially if abnormal earnings are close to zero in the long run, as many analysts assume. Thus, professional analysts rarely use more than 15 years, often fewer than 10. Comparitive income statements and retained earning statements for Illinois Tool Works (ITW) for Year 1-Year 3 follow.
REQUIRED:
1) Assume a 10 year forcasting horizon. ALso assume ITW's Year 3 return on beginning stockholders' equity (net income without extraordinary items divided by beginning Year 3 stockholders' equity) of 9.5% is expected to persist throughout the forecasting horizon (that is, that expected net income is always equal to 0.095 multiplied by beginning of the year stockholders equity). Also assume that no additional stock issuances or repurchases are made and dividends equal 25% of net income in each year. (This is ITW's approximate historical dividend payment ratio) Given these assumptions, the book value of stockholders' equity at the end of Year 4 equals book value at the beginning of Year 4 plus (1-0.25) times Year 4 net income. Finallyassume the cost of equity capital is 9%.(This is ITW's approximate cost of equity capital,) With these relatively simple assumptions, use the abnormal earnings model to estimate the total value of ITW's common shares as of the end of Year 3. Ignore termianl values at the end of the 10 year forecast horizon in your calculations.
2. As of the end of Year 3,307 million common shares were outstanding. Convert your estimate in requirement 1 to a per share estimate. For purposes of comparison, the actual market value of ITW's common shares ranged from $56 to $64 during the first quarter of Year 4.
3. Now assume the ITW will maintain a 20% return on beginning stockholders' equity over the 10 year forecast horizon. What would the company's shares then be worth?
image text in transcribed

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Financial Management

Authors: Geoffrey Knott

4th Edition

1403903824, 9781403903822

More Books

Students also viewed these Finance questions