Question 1:(20 marks)

Below are earnings per share for a firm. Year 0 earnings per share are the actual earnings per share this year. Year 1 and 2 earnings per share are forecasts produced by an analyst. The required rate of return is 7% and the firm does not pay dividends nor will they pay dividends in the future.

Year 0

Year 1

Year 2

EPS

4.8

5.2

5.7

Required:

a)Calculate abnormal earnings growth (AEG) for Year 2 using a pro forma. (4 marks)

b)What is the long-term growth rate in abnormal earnings growth (AEG) implied by market price of $160?(4 marks)

c)Using the long term implied growth rate from part (b), forecast EPS for Year 3, 4 and 5 and produce a graph of EPS growth path from year 1 to 5 with an indicator for both BUY and SELL zones.(8 marks)

d)In the context of investment decision-making, what are the advantages of using the reverse-engineering approach instead of computing the intrinsic value?(4 marks)