InSight Investments Ltd. is asked to advise a private investor, Mrs Smith, on investing in a pharmaceutical company called CurCov. InSight’s analysts decide to use a two

stage residual income valuation model (RIVM) and the capital asset pricing model (CAPM) to value the stock. Their recent estimate of the expected return on the market portfolio is 7%. The risk free rate is 1% per annum.

InSight analysts have collected the following information for CurCov:

Beta: 1.30

Current market price per share: £11.0 on the 1st January 2021

Current book value per share: £5.0 on the 1st January 2021

The expected return on equity (ROE) and book value per share at the end of each year between 2021 and 2025 are below:

2021 2022 2023 2024 2025

Book value   

2021 5.2

2022 5.5

2023 5.9

2024 6.3

2025 6.7

ROE

2021 30%

2022 25%

2023 20%

2024 15%

2025 16%

After 2025, abnormal earnings (RI) are expected to have a constant growth rate of 3%

a. Show the theoretical equivalence between the dividend discount model and the RIVM. State any necessary conditions.

b. Calculate the required rate of return for CurCov shareholders and the expected residual incomes between 2021 and 2026.

c. Estimate the intrinsic value of CurCov by using the two-stage RIVM.

d. Recommend Mrs. Smith whether she should purchase the CurCov stock based on your estimation.

e. Comment on the following statement: the residual income valuation model (RIVM) cannot be used reliably in equity valuation since the RIVM estimation uses accounting numbers that can be manipulated.