Question

Use the following information to answer questions 4- 8:

Diana wants to evaluate the stock of Eagle Inc, which is currently trading at $14.50 per share. She gathers the following information:
· Current book value per share = $9.50
· ROE = 18%
· Expected EPS for Year 1-3 = ROE times beginning book value per share
· Dividend payout ratio = 40%
· Required rate of return on equity = 10%
Question: The company's residual income per share at the end of Year 3 is closest to:

Select one:

a. $0.81

b. $0.93

c. $0.79

Given that continuing residual income will fall to zero after Year 3, the stock is most likely:

Select one:

a. Undervalued.

b. Fairly valued.

c. Overvalued.

Given that after Year 3, ROE will remain constant at 18% into perpetuity, the stock is most likely:

Select one:

a. Undervalued.

b. Fairly valued.

c. Overvalued.

Given that ROE will start to decline in Year 4 and beyond toward the required return on equity with a persistence factor of 0.7, the stock is most likely:

Select one:

a. Undervalued.

b. Fairly valued.

c. Overvalued.

Given that ROE will decline to the long-run industry average and the stock will trade at a P/B multiple of 1.6 at the end of Year 3, the stock is most likely:

Select one:

a. Undervalued.

b. Fairly valued.

c. Overvalued.

Answer 1

EPS = ROE times book value

=18% * 9.50

=$1.71 per share

Dividend Payout ratio = 40%

Residual Income per Share = 60%

Therefore, Residual Income = $1.71*60% = $1.026

Required rate of Return = 10%

The company's residual income per share at the end of Year 3 is closest to:

1.026/(1+0.1)³

= c. $0.79

2. Given that continuing residual income will fall to zero after Year 3

c. Overvalued, since there will be no income post 3 years

3. Given that after Year 3, ROE will remain constant at 18% into perpetuity, the stock is most likely:

b. Fairly valued.