P0 of common stock = BV0 + PV(E(RI))

Price = Book Value at T0 + PV of Expected RI

RI = [Investment Return (ROE) - Cost of Raising Capital (Ks)] * (BV0)

Useful summary slide on the 3 broad approaches to DCF

Net Income has taken into account the cost of debt, and so needs only to adjust for the cost of
equity to arrive at RI. However, NOPAT has yet to include both the cost of debt and equity, and
therefore is adjusted by WACC to arrive at RI.

Ks

WACC

If Residual Income +ve, it means that the

firm has generated positive abnormal
returns

NOPAT = Profit without consideration for the cost

of raising capital
NOPAT = EBIT (1 - T)

(MCAP)

Done

WACC = 0.6(0.8)(1 - 0.4) + 0.4(0.12) = 0.0768

NOPAT = EBIT(1 - T) = 400,000(1 - 0.4) = 240,000
RI = 240,000 - 0.0768(5,000,000) = -144,000
Alternatively
NI = (EBIT - Interest)(1 - T)
= (400,000 - 0.08 * 3,000,000)(1 - 0.4)
= 96,000
RI = NI - Equity Charge
Equity Charge = 2,000,000(0.12) = 240,000
RI = 96,000 - 240,000
= -144,000

(OCI)

Done

RI for Y1 = 2.5 - 20(0.1) = 0.5

BV for Y1 = 20 + 2.5 - 1 = 21.5
RI for Y2 = 3 - 21.5(0.1) = 0.85
Since RI for Y1 and Y2 is positive, the value of the
stock > BV for the stock (according to the RIM
equation for value).

Done

Value of stock = BV0 + PV(RI)

= 20 + 0.5 / 1.1 + 0.85 / (1.1^2) + 1 / (1.1^3)
21.91
The value of the stock > Book Value

Residual Income at Y1 (see equation to left)

When ROE > r, RI is +ve, and MV > BV (Justified P/B > 1)

When ROE < r, RI is -ve, and MV < BV (Justified P/B < 1)

Done

Assume constant growth

V0 = 30 + (0.18 - 0.12)(30) / (0.12 - 0.08)

= 75
ROE > r, therefore RI is +ve, and Value according to RIM
> BV

Done

80 = 30 + (0.18 - 0.12)(30) / (0.12 - 0.08)

g = 0.084

This is the terminal

value at the end of T,
computed as the
difference between
the market and book
value of the stock.

Numerator is RI for period t

RI for period T

Note that this is the PV of the terminal value of

RI for the period T and beyond.

If = 1, we have a perpetuity, and the

equation collapses into the perpetuity formula
for terminal value

Note that this is

PV(RI), computed from
period 1 up to T-1

If = 0, RI in the
final period is
treated as it
would be in any
other period, with
no additional RIs
expected to
follow it in the
future

E -r B

Terminal Value =

T E T-1
_____________

1+r-
E

Similar to accounting concept, that abnormal earnings may persist into the future.
Persistence looks at

Means continue indefinitely

Notice that if = 1, what we have is a RI that

continues into perpetuity. In accordance to the
perpetuity formula, then, we take
RIT / rE to compute the terminal value, and
T-1
discount it back to the present with (1 + r )
E

Notice that if = 0, (1 + rE) * (1 + rE)^(T - 1) =

(1 + rE)^T, making it exactly the same as the
regular equation for the PV of RI computed for
the periods 1 to T-1
This is logical given that it is the last RI simply
discounted back to the present with no future
RIs expected to be generated in the future

Done

V = 20 + 0.5 / 1.1 + 0.85 / 1.1^2 + 1 / (1 + 0.1) / (1.1^2)

21.91

Done

V = 20 + 0.5 / 1.1 + 0.85 / 1.1^2 + 1 / (0.1) / (1.1^2)

29.42

Done

V = 20 + 0.5 / 1.1 + 0.85 / (1.1^2) + 1 / (1 + 0.1 - 0.6) / (1.1^2)

22.81

Done

V = 20 + 0.5 / 1.1 + 0.85 / 1.1^2 + 1 / 1.1^3 + (27.5 - 25) /

1.1^3
23.79
The difference between the market value and the book
value at the end of the last period is treated as the
terminal value.

Done

DDM: 1 / 0.1 = 10
RIM:
RI = 1 - 7 (0.1) = 3
V = 7 + 3 / 0.1 = 10