Reference no: EM13902357

COMPUTING RESIDUAL INCOME.  The following data represent total assets, book value, and market value of common shareholders' equity (dollar amounts in millions) for three firms. Each of these firms, Southwest Airlines, Kroger, and Yum! Brands, operates in a different industry, but all of  them operate in very competitive industries. Southwest  Airlines  is  a  U.S.  domestic  airline  that  provides  low-cost point-to-point  air transportation services. Kroger operates retail supermarkets across the United States. Yum! Brands operates and franchises quick-service restaurants, including KFC, Pizza Hut, Taco Bell, Long John Silver, and A&W All American Food restaurants. These data also include existing market betas for the three firms and analysts' consensus forecasts of net income for Year +1 (in millions). Assume that for each firm, analysts expect other comprehensive income items for Year +1 to be zero; so Year +1 net income and comprehensive income will be identical. Assume that the risk-free rate of return in the economy is 4.0 percent and the market risk premium is 5.0 percent.

	SouthwestAirlines	Kroger	Yum!Brands
Total Assets	$14,308	$23,211	$  7,242
Common Equity:
Book Value	$  4,953	$  5,176	$  1,139
Market Value	$  7,490	$14,870	$15,950
Market Equity Beta	1.10	0.35	1.04
Analysts' Consensus Forecasts
of Net Income for Year +1	$     252	$  1,263	$ 1,010

Required

a. Using the CAPM, compute the required rate of return on equity capital for each firm.

b. Project required income for Year +1 for each firm.

c. Project residual income for Year +1 for each firm.

d. Rank the three firms using expected residual income for Year +1 relative to book value of common equity.

e. What do the different amounts of residual income imply about each firm? Do the projected residual income amounts help explain the differences in market value of equity across these three firms? Explain.