8.18 Interpreting Residual Income
The
above permits an alternative view of Residual Earnings which
highlights the understanding of residual earnings.
Residual income is dollar excess return over what is required
by investors in terms of the cost of equity capital times book value
of shareholders equity.
Residual Earningst = (Return on Common Equityt
– Cost of equity capital) * Book value of common equityt-1
Residual Income2010 =
(0.5029 – 0.0837)*16.881 = 7.0771
Residual Income2011 =
(0.4043 – 0.0837)*22.968 = 7.3656
Calculating the Present Value of Residual Earnings over the Stage 1
Growth Phase
The cost of equity capital equals the investors’ required rate of
return. In turn this
equals the discount rate for computing the present value of the
residual earnings over the Stage 1 growth phase.
You can verify the above as follows:
Present Value Stage 1 phase Residual Income = 30.7233 =
7.0771/(1.0837) + 7.3656/(1.0837^2) + 7.7769/(1.0837^3) +
8.2312/(1.0837^4) + 8.7328/(1.0837^5)