The following information relates to all the remaining numeric problems. Faraday
ID: 2741550 • Letter: T
Question
The following information relates to all the remaining numeric problems.
Faraday Inc.'s current book value is $2,500,000. Its common stockholders require a 14% rate of return on their investment. Faraday's comprehensiveincome, which is also its net income, is projected for the next five years as given below. Faraday has no preferred stock or minority interest. The firm gives out 25% of its net income as dividends and retains the rest. It has no other comprehensive income in future years. Faraday's comprehensive (net) income grows by 4% steady rate per year after year 5 forever.
What will be Faraday's book value of equity in year +4?
What will be Faraday's dividend in year+5?
How much is Faraday's residual income in year+1?
How much is Faraday's required income in year+2?
If Faraday's net income grows by 4% steady rate per year after year 5 forever, how much will be its continuing value at end of year+5?
What is the total present value of Faraday's residual income from year 1 through 5?
What is Faraday's total equity value based on residual income model (ignore midyear discounting)?
Now Comp. Income Year +1: $450,000 Year +2: $475,000 Year +3: $520,000 Year +4: $560,000 Year +5: $610,000Explanation / Answer
1) Book value of equity in year 4 will be
Book value is for a particular year is calculated as = Previous year book value+ Net income- Dividend
Since dividend is 25% of net income for a particular year
Book value for the year 4 will be= Current book value will be+ Net income from 1-4 years - Dividend for year 1-4
=25,00,000+(450000+475000+520000+560000) - .25%(450000+475000+520000+560000)
because dividend paid is 25% of net income
=4003750
2) Dividend in year 5 will be 25% of net income in year 5
which is =610000*.25
=152500
3) Residual income is the income remaining after paying to equity shareholders and it is calculated as
R.I FOR YEAR 1 =Net income for Year 1- (Book value at beg of year 1 *ROE required by equity shareholders)
=450000-(.14*25,00,000) which is 100000
4) Since shareholders wnat a return of 14% on their equity value and return is calculate don value at the beginning of year so value of equity at the starting of year 2 will be
Current book value+ Net income of year 1 - Dividend paid to shareholders
=2500000+450000-(.25%*450000)= 2837500
Return required to shareholders=.14*2837500
which is 387250
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