E&K company has a net book value of $220,000. The company has a 10% cost of capi

Question

E&K company has a net book value of $220,000. The company has a 10% cost of capital. The firm expects to have profits of $45,000, $40,000 and $35,000 for the next 3 years. The company pays no dividends and deprectiation is 5% per year of book value.

a. using the excess earnings model, should the firm be valued atmore or less than its book value?

b. What, if anything, are the company's abnormal earnings for the next 3 years?

c. What is your best estimate of the firm's value using the excess earnings model?

Explanation / Answer

a. Using excess earning model, firm be valued at more than book value, since it has excess earningper year which will generate Goodwill value of the company.

b. If there are company's abnormal earning in next 3 year then excess earning of the company will be NIL as excees earning model does not consider Profits of Abnormal years, Hence there will be no Goodwill value to the firm.Hence company's value should be equal to book value.

c.The best estimate of the firm's value using the excess earnings model is $ 510000.

WN1)

AVERAGE NET EARNING PER YEAR= $ (45000 + 40000 + 35000) / 3 = $ 40000

ANNUAL DEPRECIATION ( 5% OF $ 220000) = $ 11000

EXCESS EARNING = $ ( 40000 - 11000) = $ 29000

CAPITALISED AVERAGE EARNING ATTRIBUTABLE TO GOODWILL = $ 29000 / 10% = $ 290000

ESTIMATED FIRM'S VALUE = $ 220000 + $ 290000 = $ 510000.

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