Residual income valuation

Residual Income

Valuation

Concepts• Residual Income (RI), or economic profit, is the

net income of a firm less a charge that measures stockholder’s opportunity cost of capitalo RI = Net Income – (Equity Capital * Cost of Equity)

• Economic Value Added (EVA) is the value added for shareholders by management during a given yearo EVA = NOPAT – (WACC * Invested Capital)o A parameter usually used to reward management’s performance

• Market Value Added (MVA)o MVA = Market value of long term debt and equity – Book Value of

Invested Capital o It measures the value created by management’s decisions since

inception

Problem QsMadeira Fruit Suppliers, Inc. (MFS) distributes fruits to grocery stores in large U.S. cities. The book value of its assets is $1.4 billion, which is financed with $800 million in equity and $600 million in debt. Its before tax cost of debt is 3.33%, and its marginal tax rate is 34%. MFS has a cost of equity of 12.3%. MF’s abbreviated Income Statement is as follows: -

Calculate Residual Income for MFS.

EBIT $142,000,000

Less: Interest Expense (20,000,000)

Pre tax Income 122,000,000

Less: Income Tax Expense

(41,480,000)

Net Income $80,520,000

Forecasting RI

• RIt = residual income in year t

• Et = expected EPS in year t

• r = required return on equity• Bt-1 = book value of equity in year t-1

• ROE = expected return on equity

RI Valuation Model

• Stock’s intrinsic value V0 is equal to its current book value per share plus the present value of all its expected future residual incomes