Question

Fristy Corporation has a book value of equity of $5,000 at the beginning of 2005, and net income of $1,000 for year ended 2005. It pays no dividends and its cost of equity capital is 10%. It expects return on beginning of year equity to remain constant for 2006 and 2007 and decrease to 10% thereafter. What should its price to book value be at the end of 2005 (pick closest number)? A: 1.01 B:1.05 C:1.09 D: 1.19

Answer 1

D.1.19.

working:

let us find out the value of firm.

year	return	discounting factor	return * discounting factor
2006	1000	1/(1.10)^1=>0.90909	909.09
2007	1000	1/(1.10)^2=>0.82645	826.45
2007	(see note)5000	1/(1.10)^2=>0.82645	4132.25
		Total value	5867.79

price to book value = 5867.79 /5000

=>1.173558

=>closest to 1.19.

note:

horizon value at end of 2007.

existing return on equity = 1000/ 5000=>20%

if the return decreases to 10%, net income after 2007 would be = 5000*10% =>500.

so horizon value would be => 500 return / 0.10 cost of equity

=>5000