CAS Exam 7 Spring 2013, Question 12
Study guide: Exam 7
Beginning in 2013, an insurance company entered a niche market that other companies had not yet entered. The company plans to grow aggressively in this market. Given the following information for this insurance company:
| Calendar Year Projections ($000,000) | 2013 | 2014 | 2015 |
|---|---|---|---|
| Beginning US GAAP equity | 1,000 | 1,105 | 1,221 |
| Net income | 150 | 166 | 183 |
| Dividends to be paid at year-end | 45 | 50 | 55 |
- Risk-free rate: 2.0%
- Expected equity market risk premium: 6.0%
- Insurance company equity beta: 1.5
- CAPM is an appropriate model for determining the company's risk-adjusted discount rate.
- The company's plan is to continue its current dividend payout ratio.
Part a (2 points)
Determine the value of this company as of January 1, 2013 based on the abnormal earnings valuation method. Assume that after the forecast horizon abnormal earnings will decrease to zero, linearly, by 2020.
Part b (0.5 points)
Explain why an investor might prefer the abnormal earnings valuation method over the dividend discount model valuation for this particular company.
No current syllabus covers this question; it is kept for the record.
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