COMPUTING RESIDUAL INCOME. The following data represent total assets, book value, and market value of common shareholders' equity (dollar amounts in millions) for Abbott Labs, IBM, and Target Stores. Abbott Labs manufactures and sells health care products. IBM develops and manufactures computer hardware and offers related technology services. Target Stores operates a chain of general merchandise discount retail stores. In addition, these data 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.
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Abbott Labs
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IBM
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TargetStores
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Total Assets
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$42,419
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$109,524
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$44,106
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Common Equity:
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Book Value
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$17,480
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$ 13,466
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$13,712
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Market Value
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$83,050
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$166,420
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$34,600
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Market Equity Beta
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0.27
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0.73
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1.09
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Analysts' Consensus Forecasts
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of Net Income for Year +1
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$ 5,750
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$ 12,956
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$ 2,384
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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. 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.