Answer:
The abnormal earnings model is a method of analyzing a company's value based on its earnings. It assumes that the company's earnings are not entirely due to its assets and liabilities but also due to other factors such as management expertise, brand value, and other intangible assets. The model calculates the value of a company by adding its book value to the present value of its future residual earnings. Residual earnings are calculated as the difference between the company's actual earnings and its expected earnings based on its book value and expected return on equity.
Here are the steps to calculate the value of the company according to the abnormal earnings model:
1. Calculate the cost of equity using the capital asset pricing model (CAPM). The CAPM formula is:
Cost of Equity = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate)
Using the given values:
Cost of Equity = 1.4% + 1.56 * (12% - 1.4%) = 18.24%
2. Calculate the expected earnings for each year using the formula:
Expected Earnings = Book Value * (Cost of Equity - Expected Return on Equity)
Using the given values:
Expected Earnings for 2021 = £240 million * (18.24% - 12%) = £33.984 million
Expected Earnings for 2022 = £240 million * (18.24% - 12%) = £56.640 million
Expected Earnings for 2023 = £240 million * (18.24% - 12%) = £68.352 million
Expected Earnings for 2024 = (£240 million * (18.24% - 12%)) * 1.02 = £69.7536 million
3. Calculate the residual earnings for each year using the formula:
Residual Earnings = Actual Earnings - Expected Earnings
Using the given values:
Residual Earnings for 2020 = £70 million - (£240 million * 12%) = £38 million
Residual Earnings for 2021 = £90 million - £33.984 million = £56.016 million
Residual Earnings for 2022 = £150 million - £56.640 million = £93.36 million
Residual Earnings for 2023 = £180 million - £68.352 million = £111.648 million
Residual Earnings for 2024 = £69.7536 million
4. Calculate the present value of residual earnings using the formula:
Present Value of Residual Earnings = Residual Earnings / (Cost of Equity - Expected Growth Rate)
Using the given values:
Present Value of Residual Earnings for 2021 = £56.016 million / (18.24% - 2%) = £364.8 million
Present Value of Residual Earnings for 2022 = £93.36 million / (18.24% - 2%)^2 = £508.8 million
Present Value of Residual Earnings for 2023 = £111.648 million / (18.24% - 2%)^3 = £609.6 million
Present Value of Residual Earnings for 2024 = £69.7536 million / (18.24% - 2%)^4=£318m
5. Calculate the total value of the company by adding its book value to the present value of residual earnings.
Total Value of Company= Book Value + Present Value of Residual Earnings
Using the given values:
Total Value of Company=£240m+£364m £508m+£609m+£318m=£2039m
Therefore, according to this model, the value of this UK Company trading on London Stock Exchange is approximately **£2039m**.