Question

Use the following information to estimate the intrinsic value of VIM’s common stock using the residual income model: VIM had total assets of $ 3,000,000, financed with twice as much debt capital as equity capital. VIM’s pre-tax cost of debt is 6 percent and cost of equity capital is 10 percent. VIM had EBIT of $300,000 and was taxed at a rate of 40 percent. EBIT is expected to continue at $300,000 indefinitely. VIM’s book value per share is $ 20. VIM has 50,000 shares of common stock outstanding.

Answer 1

Ans : Residual Income is the income generated by the company after providing for the cost of capital of the company.

Equity Capital = No. of Shares * Book Value per share
= 50,000 shares * $20 per share
= $1,000,000

Total Assets = $3,000,000
Equity = $1,000,000
Debit = Twice of Equity capital = $2,000,000

EBIT	$300,000
(-) Interest	$(120,000)
Earnings Before Taxes	$180,000
(-)Taxes (40%)	$(72,000)
Earnings after Taxes	$108,000
(-)Cost of Equity Capital	$(100,000)
Residual Income	$8,000

Hence Residual income per share = 8000 / 50000 = $0.16 per share

Intrinsic Value = Book Value + Present Value of Residual Income
= $1,000,000 + 8000/0.10
= $1,080,000

Intrinsic Value per share = $1,080,000 / 50000 shares = $21.6 per share