This case is based on a factual situation facing the courts. Allen Questrom, recently retired Chief Executive Officer (CEO) of Federated Department Stores, is suing the company for the amount of incentive compensation he earned during the five years he was Federated's CEO. This incentive compensation was to be based on the increase in the firm's total equity value over this five‐year period, a time during which Questrom rescued the retailer from bankruptcy. Questrom and Federated are in dispute over Federated's equity value as of January 28, 1995. Therefore, the court is being asked to estimate Federated's equity value as of January 28, 1995 and then determine the amount of compensation that Federated owes Questrom.
The presiding judge (Gilbert Snider) wants you to analyze selected information from Federated's financial statements. As part of your analysis, the judge has asked you to explain the role that certain components of the financial statements have with respect to firm valuation. You are asked to estimate Federated's total equity value as of January 28, 1995 (the end of the five‐year period under consideration) using the “free cash flow” and the “residual income” valuation models. The “residual income” model, which combines historical financial accounting and earnings forecasts to value companies, has generated considerable excitement in financial accounting academic circles and among accounting and consulting practitioners. Variants of the residual income valuation model, such as Stern and Stewart's EVA® (Economic Value‐Added) and McKinsey's Economic Profit Model, have been widely discussed by academics and utilized by consultants to value businesses in a variety of settings and purposes.