Calculating Present Value of Abnormal Earnings
What is the process for calculating the present value of abnormal earnings at time t+1?
The present value of abnormal earnings at time t+1 can be calculated by determining the abnormal earnings for that period and then discounting them to their present value using the cost of equity.
Calculating Present Value of Abnormal Earnings at time t+1
- Beginning book value of equity = $50,000
- Net income = $10,000
- Cost of equity = 12% To calculate the present value of abnormal earnings at time t+1, we need to determine the abnormal earnings for that period. Abnormal earnings can be calculated as the difference between the actual earnings (net income) and the expected earnings. In this case, the net income is $10,000. To calculate the expected earnings, we need to determine the return on equity (ROE). ROE is calculated as the net income divided by the beginning book value of equity. The ROE in this case is 0.2 or 20%. The expected earnings can be calculated by multiplying the beginning book value of equity by the ROE, resulting in $10,000. The abnormal earnings for t+1 would be the actual earnings minus the expected earnings, which in this case is $0. To calculate the present value of abnormal earnings at time t+1, we need to discount the abnormal earnings to their present value using the cost of equity. The formula to calculate the present value of abnormal earnings is: Present Value = Abnormal Earnings / (1 + Cost of Equity). Plugging in the values, we get: Present Value = 0 / (1 + 0.12) = $0. Therefore, the present value of abnormal earnings at time t+1 would be $0.