Determining abnormal earnings-Some examples (LO6-1) As discussed in the chapter,
ID: 2820910 • Letter: D
Question
Determining abnormal earnings-Some examples (LO6-1)
As discussed in the chapter, abnormal earnings (AE) are
AEt = Xt (re × BVt1)
where Xt is the firm’s net income, re is the cost of equity capital, and BVt-1 is the book value of equity at time t 1.
Required:
Solve the following problems: (Negative amounts for any of your answers should be indicated by a minus sign.)
If Xt is $5,000, re = 15%, and BVt-1 is $50,000, what is AEt?
If Xt is $25,000, re = 18%, and BVt-1 is $125,000, what is AEt?
Assume the firm in requirement 2 can increase Xt to $30,000 by instituting some cost-cutting measures. What is the new AEt?
Assume the firm in requirement 2 can divest $25,000 of unproductive capital with Xt falling by only $2,000. What is the new AEt?
Assume the firm in requirement 2 can add a new division at a cost of $40,000, which will increase Xt by $7,600 per year. Would adding the new division increase AEt?
Assume the firm in requirement 1 can add a new division at a cost of $25,000, which will increase Xt by $3,500 per year. Would adding the new division increase AEt?
1. AEt 2. AEt 3. AEt 4. AEt 5. Would adding the new division increase AEt? 6. Would adding the new division increase AEt?Explanation / Answer
Answer 1:
AEt = Xt - (Re * BV(t-1) )
Xt = 5000
Re = 15%
BV(t-1) = 50000
AEt = 5000 - .15*50000 = - 2500
Answer 2.
AEt = 25000 - .18*125000 = 2500
Answer 3.
Cost cutting measures will reduce the expenses, but do not have any impact on the Book value of the company.
AEt = 30000 - .18*125000 = 7500
Answer 4:
Case 1: Divestment of unproductive capital will increase the Cash (Current assets) and reduce the fixed assets (Non current assets). Therefore the overall book value of the company will remain same, i.e unchanged.
BV = 125000
Current Net income Xt = 25000 -2000 = 23000
AEt = 23000 - .18*125000 = 500
case 2:
If The unproductice capital is funded by debt, then the debt will be reduced by 25000 and the fixed asset will also be reduced by 25000. Therefore the overall book value will be reduced by 25000.
The current book value = 125000 -25000 = 100000
Net income = 25000 - 2000 = 23000
AEt = 23000 - .18*100000 = 5000
Answer 5 & 6:
Similar approach (answer 4) will be applicable in the following questions (5 & 6)
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