Creative Gardening is expected to have a return on equity (ROE) of 13% for the next five years and 10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $7.50 per share and its required rate of return is 10%. The premium over book value at the end of five years is expected to be 30%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $1.10. The projected ending book value in year 5 is $13.83. What is the value of Creative Gardening using these inputs? A) $11.18. B) $13.83. C) $8.60. The correct answer was A. Applying the finite horizon residual income valuation model: V0 = B0 + sum of discounted RIs + discounted premium = 7.50 + 1.10 + [(0.30)(13.83)/(1.10)^5] = $11.18 ---------- I am not seeing how the last part (discounted premium) was done and think it may be a mistake on their part. Page 287 of Schweser Book 3 says that PV continuing residual income = [(P-B) + RI] / (1+r). In this problem, it looks like they’re directly applying the premium of 30% to the BV–but they neglect to add the RI. The two ways of doing it should be equivalent. For example, assume P = 10, BV = 8, RI = 20, and premium = 25% since 10 is 25% more than 8. (P - B) + RI = (10 - 8) + 20 = 22 (P% x BV) + RI = (0.25 x 8 ) + 20 = 22 So, if you want to directly multiply the BV by the premium you can, but you MUST add back the RI to get the same numerator, which is neglected in their solution. Please help to understand if this is an error on their part.
sum of pv of all ri for the next 5 years is 1.10 that has been added now the only thing left is the premium over BV - which is 30% also provided. I don’t see any issue there.
cpk, not sure if you have the schweser books this year, but if take a look at the problem on page 287 (question given on page 285), you will see that in the final year, they add that year’s RI to the premium of P - B. Is the difference between that problem and this one here simply that here the final year’s RI is already included, therefore you don’t have to add it in the final year–whereas in the book the RI is found year by year so it is summed to the P-B in the final year?
Like CPK123 said that’s already been factored in. Notice when they add RI in Schweser its for period (T-1), however for period T, its just the premium that should be added. It says that on the same page. A few lines above.