Question

At the beginning of 2017, investors had invested $25,000 of common equity in Grant Corp. and expect to earn a return of 11% per year. In addition, investors expect Grant Corp. to pay out 100% of income in dividends each year. Forecasts of Grant's net income are as follows: 2017: $3,500 2018: $3,200 2019: $2,900 2020 and beyond: $2,750 (no growth) Use this information to compute Grant Corp.'s expected residual income for the year 2017?

Answer 1

$750.

Step-by-step explanation:

By Capital assets Pricing Model,

Equity Charge:

= Equity Capital × Cost of Equity

= 25,000 × 0.11

= $ 2750

If in year 2017, Net income = $ 3500,

then Residual income = Net income - Equity Charge

= 3500 - 2750

= $750.

Since residual income is positive, Its profitable and growth venture from a shareholder's perspective.