I’m confused by the last term in the finite horizon model which is: V= B0 + sum of discounted RI + PV of (Pt - Bt) From reading the CFAI book as well as Schweser it looks like its simply the difference between the market value and book value (the premium). In question 15 of CFAI reading 45 they multiply this premium by the book value in year T. Why do they do that? Here’s the question: Use the following inputs and the finite horizon form of the residual income model to computer the value of Southern Trust Bank (STB) shares as of Dec 31 2007: ROE will continue at 15% for the next 5 years (and 10% thereafter) with all earnings reinvested (no dividends paid) Cost of equity = 10% B0 = $10 per share (at the end of 2007) Premium over book value at the end of 5 years will be 20%
Premium = Pt - Bt In the above statement they are telling you that Pt = 1.2 Bt
What confuses me is that Schweser says “Recall from the single-state residual income model that market value equals book value plus the present value of residual income. Therefore, at any point in time (T), the present value of future residual income is the difference between market value (Pt) and Book Value (Bt)” I took that to mean that b/c MV = B0 + PV of RI, PV of RI = MV - B0, which is the premium given in the problem So if your given the premium, why aren’t you discounting that value? Why do you multiply the premium by the book value before discounting?
Also, my question with this one was isn’t it P0 = E1/R + PVGO? You are given the current price and the current EPS, so wouldn’t you have to multiply the 29 by (1+g) just as you would for moving D0 to D1 with the DDM? 20. Current EPS=2.40 Current Stock price=29 Cost of Equity=10% Return on Book Equity=12% Sustainable Growth Rate=4% So P=E/R+PVGO 29=2.4/0.1 + PVGO PVGO=29-24=5$
anyone?
formula is V0 = E1/r + PVGO so no multiplication by the (1+g) anywhere.
I just missed another practice problem on this. For the continuing RI formula, the terminal value is given in the CFAI book as premium over book value discounted back at the cost of equity at time T or (Pt - Bt) / (1+r)T. In Schweser, its given as premium over book value + RI discounted back at the cost of equity at time T-1 or [(Pt - Bt) + RIt] / (1+r). In the practice problem #15 in the CFAI book they do premium times previous BV discounted back. So I don’t get why they multiply the premium in the example or how your supposed to handle this.