Residual Income Question

Current stock price = 8.75

current BV = 7.25

expected ROE for next 4 years = 16%

required return on equity = 12%

no dividends

persistence factor is 0.3 after year 4

Based on residual income model, intrinsic value is

A) 8.95

b) 8.45

Answer B. The solution uses the residual income in year 4 to calculate the pv of continuing residual income and adds it to RI(t3). Isn’t this ignoring the year 4 cashflow?

Persistence factor is a function of a perpetual discount factor so it is added to the second last cash flow which will have the perpetuity.

RIt3 = RIt3 + RIt4/(1+r-w)

B0 + B0*1,16(.04)+B0*1.16^2(.04)+[B0\*1.16\*3(.04)+B0\*1.16^4\*(.04)/(0.82)] = $8.5~