13.14 Computing Residual Income.

a. Required return on equity capital:

Microsoft.................. 4.0% + (0.96 × 5.0%) = 8.80%
Intel .......................... 4.0% + (1.12 × 5.0%) = 9.60%
Dell........................... 4.0% + (1.28 × 5.0%) = 10.40%

b. Required Income:
Microsoft.................. 8.80% × $39,558 million = $3,481 million
Intel .......................... 9.60% × $39,088 million = $3,752 million
Dell........................... 10.40% × $4,271 million = $444 million

c. Residual Income:
Microsoft.................. $16,250 million – $3,481 million = $12,769 million
Intel .......................... $8,060 million – $3,752 million = $4,308 million
Dell........................... $1,882 million – $444 million = $1,438 million

d. The rankings based on residual income relative to book value of equity in

Year +1 are as follows:
Dell........................... $1,438 million/$4,271 million = 33.7%
Microsoft.................. $12,769 million/$39,558 million = 32.3%
Intel .......................... $4,308 million/$39,088 million = 11.0%
e. The residual income amounts imply that all three firms will create substantial
amounts of shareholder wealth in Year +1. Microsoft is the largest firm of the
set and will create the largest amount of shareholder wealth (nearly $13 billion)
in Year +1, whereas Intel will generate over $4 billion of shareholder wealth in
Year +1, and Dell will create over $1.4 billion in shareholder wealth in Year
+1. Even though this is the smallest dollar amount of residual income, Dell is
creating the highest residual ROCE. Microsoft has the largest book value of
equity of this set of firms and the largest residual income (at least in Year +1),
which partially explains why it has the largest market value of equity.
13.16 Equity Valuation Using the Residual Income Model.
Morrissey Tool Company:

a. Comprehensive Required Residual Present Value Present

Year Income Incomea Income Factor Value
+1 $213,948 $133,337 $80,611 0.89286 $ 71,974
+2 $192,008 $151,309 $40,699 0.79719 32,445
+3 $187,444 $167,437 $20,007 0.71178 14,240
+4 $196,442 $183,183 $13,259 0.63552 8,427
+5 $206,667 $199,684 $ 6,983 0.56743 3,963
Present Value of Residual Income, Year +1 to Year +5.............. $ 131,049
Present Value of Continuing Value:
+6 $217,000 $217,044 $(44)
($44) × [1/(0.12 – 0.05)] = $(629); $(609) × 0.56743 = ($357)
Common Shareholders’ Equity, January 1, Year +1 ................... 1,111,141
Total Value................................................................................... $1,241,833
Midyear Adjustment: $1,241,833 × [1 + (0.12/2)] ...................... $1,316,343
a
Amounts equal 12% of common shareholders’ equity at the beginning of the
year. Common shareholders’ equity changed each year as follows:

Comprehensive
Year Start of Year + Income – Dividends = End of Year
+1 $1,111,141 $213,948 $64,184 $1,260,905
+2 $1,260,905 $192,008 $57,602 $1,395,311
+3 $1,395,311 $187,444 $56,233 $1,526,522
+4 $1,526,522 $196,442 $58,933 $1,664,031
+5 $1,664,031 $206,667 $62,000 $1,808,698
+6 $1,808,698 $217,000 $65,100 $1,960,598

b. Kelsey should consider keeping the firm as long as it generates a return that
exceeds her cost of capital. Her firm will generate positive residual income,
in declining amounts, through Year +5. Residual income turns negative in
Year +6. Growing comprehensive income by 5% each year will yield ever-
increasing negative residual income beginning in Year +6. Thus, the firm will
lose value in Year +6 and beyond if the required rate of return is 12%. Kelsey
should consider selling the firm at or before Year +5. The rate of return on
common shareholders’ equity, with equity measured as of the beginning of the
year instead of on average over the year, is as follows:

Year +1: $213,948/$1,111,141 = 19.3%

Year +2: $192,008/$1,260,905 = 15.2%
Year +3: $187,444/$1,395,311 = 13.4%
Year +4: $196,442/$1,526,522 = 12.9%
Year +5: $206,667/$1,664,031 = 12.4%
Year +6: $217,000/$1,808,698 = 12.0%