CAS Exam 7 Spring 2018, Question 19
Study guide: Exam 7
A company's equity is valued at $276,716,000 based on the following assumptions:
| 2018 | 2019 | 2020 | |
|---|---|---|---|
| Net Income ($000) | 22,000 | 28,000 | 34,000 |
| Starting GAAP Equity ($000) | 189,200 | 190,300 | 191,700 |
- The risk free interest rate = 4.0%.
- The equity market risk premium = 5.0%.
- The company's beta = 0.8.
- After 2020, the company's abnormal earnings decrease linearly until reaching zero in 2031.
Financial ratios for several peer companies are summarized below:
| Price/Earnings | Price/Sales | Price/Cash Flow | Price/Book | |
|---|---|---|---|---|
| Peer 1 | 12.5 | 1.0 | 8.0 | 1.29 |
| Peer 2 | 13.4 | 0.9 | 7.7 | 1.59 |
| Peer 3 | 12.5 | 2.1 | 14.1 | 1.37 |
| Peer 4 | 12.9 | 4.5 | 12.8 | 1.76 |
Part a (1.5 points)
Calculate the change in the estimated equity value if the abnormal earnings are assumed to decrease linearly to zero in 2023 instead of in 2031.
Part b (1 point)
Justify whether 2 years or 10 years of non-zero abnormal earnings after 2020 produces a more reasonable answer.
No current syllabus covers this question; it is kept for the record.
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