CFA 2018 Quest bank 06 Residual Income Valuation

Test ID: 7441466

Residual Income Valuation

Question #1 of 63

Question ID: 463488

ᅚ A) ᅞ B) ᅞ C)

Question #2 of 63

Question ID: 463464

ᅚ A) ᅞ B) ᅞ C)

Question #3 of 63

Question ID: 463527

ᅚ A)

Creative Gardening isexpectedto havea returnonequity (ROE)of13% for thenextfive yearsand10% thereafter, indefinitely. Its current book value per shareasofthebeginningof year 1 (i.e., theendof year 0)is $7.50 per shareandits required rateof returnis10%.

The premiumover book valueattheendoffive yearsisexpectedto be30%. Allearningsare reinvested. Thesumofthe present values ofthe residualincomeestimatesover thenextfive yearsis $1.10. The projectedending book valuein year 5 is $13.83. Whatisthe value

ofCreative Gardening using theseinputs?

$11.18.

$8.60.

$13.83.

Explanation

Applying the finite horizon residual income valuation model: V = B + sumofdiscountedRIs + discounted premium

=

7

.50 +

1

.

1

0 + [(0.

3

0

)

(

13

.8

3)

/(

1

.

1

0

)

] = $

11

.

1

8

Economic valueadded (EVA )iscalculatedasnetoperating profitafter taxesminus:

a charge for total capital. achargefor equity capital.

capitalexpenditures.

Explanation

EVA = NOPAT - (C% × TC), where NOPATisafirm'snetoperating profitafter taxes, C% isthecostofcapital, andTCistotalcapital.

An analystusesthe financialstatementsofAdvancedInstrumentsto generate the following estimates: Book Value per share = 4.00

Dividend retention ratio = 75% ROE = 17%

Ifthe required rate of return is15%, andthe currentshare price is $7.56 per share, the stock (using asingle-stage residual income model) is mostlikely:

correctlyvalued.

0 0

5

ᅞ B) ᅞ C)

Question #4 of 63

Question ID: 463510

ᅚ A) ᅞ B) ᅞ C)

Question #

5

of 63

Question ID: 463520

ᅚ A) ᅞ B)

ᅞ C)

Question #6 of 63

Question ID: 463498

ᅚ A)

undervalued. overvalued.

Explanation

g = retention ratio × ROE = (0.75) × 0.17 = 0.1275 or 12.75%

The present valueof GB Industries' projected residualincome (RI) for the next five yearsis 70 per share. Beyond thattime horizon, a key analyst projectsthatthe firm willsustain a RI of 15 per share, which isthe RI for year 5. Given a costof equity of 12%, whatisthe

terminal valueof thestock asof year 5?

£125.00.

£500.00.

£560.00.

Explanation

The stock'sterminal value asof year 5 is: TV = 15.00/0.12 = 125.00

The residualincome approach is NOT appropriate when:

the clean surplus accounting relation is violated significantly.

a firm does not pay dividendsor thestream of paymentsistoo volatileto besufficiently predictable.

expected free cash flows are negative for the foreseeable future.

Explanation

The residualincome approach is not appropriate when the clean surplus accounting relation is violated significantly. Both remaining responses describe circumstancesin which the approach is appropriate.

Midland Semiconductor hasa book value of $10.50 per share. The company's returnon equity is20%, and its required return on equity is17%. The dividend payout ratio is30%. What isthe value ofthe sharesusing asingle-stage residual income model?

ᅞ B) ᅞ C)

Question #7 of 63

Question ID: 463492

ᅞ A) ᅞ B) ᅚ C)

Question #

8

of 63

Question ID: 463489

ᅞ A) ᅚ B) ᅞ C)

$10.50. $31.50.

Explanation

g = retention ratio × ROE = (1 − 0.30) × 0.20 = 0.14or 14%

Professor Cliff Webley made thefollowing statements in his asset-valuationclass:

Statement 1: "Residual incomeapproaches generally model ROE as approaching zero over time."

Statement 2: "Ifactual return onequity equals required return onequity, the residual incomemodel sets thecompany's proper market valueequal to its book value."

Statement 3: "Using consistent assumptions, the single-stage residual incomemodel should give you the same valuationas the Gordon Growth Dividend-discount model."

Which of Webley's statements is leastaccurate?

S_{tatement 2}. Statement 3. Statement 1.

Expl_an_ation

In_acom_pe_ti_ti_vem_arke_t, R_{OE has b}eenfound _todeclineo_ve_{r t}ime _-- no_{t t}o _ze_ro _bu_{t t}o _theco_st ofe_qui_ty. T_hu_{s, r}e_sidu_al income_appro_ac_he_s of_tenmodelR_OE f_adin_{g t}o_ward _theco_st ofe_qui_ty. A_s R_{OE appr}o_ac_he_{s th}eco_st ofe_qui_{ty, r}e_sidu_alincome approaches zero. Theother two statements areaccurate.

Brown Manufacturing's recent financial statements reporteda book valueof $9.50 per share; its required rateof returnis 10%. An_al_yst Ton_{y G}i_ancol_a, C_FA_{, wa}n_{ts t}oc_alcul_ate _thecom_pan_y's in_trin_sic _valueu_sin_{g a}mul_ti_stage _re_sidu_alincome _wi_{th a h}i gh-growth RIfor thenext 5 ye_ars. Gi_ancol_acre_ates thefollowing e_stim_ate_s:

PVofinterim high-growth RIfor thenext 5 years is $3.10 At theendof year 5, the PVofcontinuing RIis $10.00 Estim_atedBoo_k V_aluein _{5 y}e_ars i_{s $}2_5.00

Whic_h of _thefollo_win_g i_{s closestto th}ec_urre_{nt intrinsi}c _val_ueo_fBro_{wn Manufa}c_turing? $13.10.

$18.81. $22.60.

Question #

9

of 63

Question ID: 463503

ᅚ A) ᅞ B) ᅞ C)

Question #1

0

of 63

Question ID: 463518

ᅞ A) ᅞ B) ᅚ C)

Question #11 of 63

Que_stio_{n ID: 463499}

Appl_{ying th}e_mul_tistage _re_sidual_inco_me_mo_del_:

V

= B

+ PV

o

_{f int}

e

_{rim high-gr}

o

_{wth RI + PV}

o

_f

co

_{ntinuing RI}

= 9.50 + 3.10 + [(10.00) / (1.10)

] = $18.81

Aninvestor isconsidering the purchaseof Microscopics, which hasa priceto book value (P/B) ratioof4.00. Returnonequity (ROE)is

expectedto be12%, current book value per shareis $12.00, andthecostofequity is10%. What growth rateisimplied by thecurrent P/B rate_?

9.33%.

10.00%.

0.67%.

Expl_anatio_n

The P/B ratioof4.00 andthecurrent book value per shareof $12.00 imply acurrentmarket priceof $48.00. Thisimpliesa gro_{wth rat}eo_f:

g = r - [{B (ROE - r)} / {V - B}] = 0.10 - [{12.00(0.12 - 0.10)} / {48.00 - 12.00}] = 0.0933 = 9.33%. Notethatthereadinginthecurriculumdoesnotprovidethisexpressiondirectly.

The residualincomeapproach isappropriate when:

a firm pays high dividends that are quite stable.

thecle_ansurpl_usacco_{unting r}el_atio_{nis vi}ol_ate_dsignific_antl_y.

expectedfreecash flowsarenegativefor theforeseeablefuture.

Explanation

The residualincomeapproach isappropriate whenexpectedfreecash flowsarenegativefor theforeseeablefuture. Itisnotappropriate

whe_nthecle_ansurpl_usacco_{unting r}el_atio_{nis vi}ol_ate_dsignific_antl_{y. Afirmthat pays high divid}e_ndsthatare _quite_stable_isal_so_{a p}oo_r c_andidate_fo_{r th}e_appro_ac_h.

Big Sky Ranches reportedthefollowing for theendofitsfiscal year: Reve_nue_s = $40.8 mill_io_n.

Pretax income = $8.6million. Assets = $53.2million. Liabil_itie_{s = $27.8 mi}ll_io_n.

0 0

5

ᅞ A) ᅚ B) ᅞ C)

Question #12 of 63

Question ID:463505

ᅚ A) ᅞ B) ᅞ C)

Question #13 of 63

Question ID:463487

ᅚ A)

Divide_{nds p}e_{r shar}e _{= $0.35.} Share_so_utstanding = 8 mill_io_n. Tax rate = 35%.

The betafor Big Sky Ranchesis1.2, thecurrent risk-free rateis4.5%, andtheexpected returnonthemarketis12.5%. What isthe valueofthesharesusing asingle-stage residualincomemodel?

$8.10. $11.28. $23.23.

Expl_anatio_n

Afte_{r tax} e_{arnings = Pr}e_tax e_{arnings × (1 − T) = 8.6mi}ll_io_{n × (1 − 0.35) = $5.59 mi}ll_io_n EPS = After tax earnings/sharesoutstanding = $5.59 million / 8 million = $0.70 Retention ratio = (0.70 − 0.35) / 0.70 = 0.50 or 50%

Equity = Assets − liabilities = $53.2million − $27.8 million = $25.4million

Book value per share = Totalequity/sharesoutstanding = $25.4million / 8 million = $3.18 ROE = $0.70 / $3.18 = 0.22o_{r 22%}

g = re_te_ntio_{n rati}o _{× ROE = (0.50) × 0.22 = 0.11}o_{r 11.00%} Expected return = 0.045 + [0.125 − 0.045]1.2 = 0.1410 or 14.10 %

Co_{ntinuing r}e_sidual_inco_me_isde_fine_dasthe_:

r_{esidual income t}h_{at is expected beyond t}h_{e initial fo}r_{ecast time} h_or_izon.

residualincomethatforcesthenet present valueto zero.

pe_rmane_ntaso_ppo_se_dto_the_transito_{ry part}o_{f r}e_sidual_inco_me_.

Expl_anatio_n

Co_ntinuing re_sidual_inco_me_isde_fine_dasthe re_sidual_inco_me_thatisexpec_te_d beyo_ndthe_initial_forec_asttime horizo_n. Itco_me_sinto pl_ay whenRIisforecastfor adefinedtime horizonandaterminal value basedoncontinuing RIisestimatedattheendofthattimeframe.

The _re_sidual_inco_me_appro_ac_{h isappr}o_priate _whe_n:

a fir_{m does not pay dividends o}r _th_{e payments a}r_{e too volatile to be sufficiently}

ᅞ B) ᅞ C)

Question #14 of 63

Question ID:463475

ᅚ A) ᅞ B) ᅞ C)

Question #1

5

of 63

Que_stio_{n ID:463477}

ᅞ A) ᅚ B) ᅞ C)

thecleansurplusaccounting relationis violatedsignificantly.

afirm pays high dividendsthatare quitestable.

Expl_anatio_n

The _re_sidual_inco_me_appro_ac_{h isappr}o_priate _whe_nafirmdoe_sno_{t pay divid}e_ndso_{r th}e _payme_ntsare_too _vol_atile_to _be_suffic_ie_ntl_y

pre_dic_table. Itisno_tappropriate whe_nthecle_ansurpl_usacco_unting rel_atio_nis viol_ate_dsignific_antly. Afirmthat pays high divide_ndsthat

are quitestableisalsoa poor candidatefor theapproach.

Travel_Adviso_{rs has}e_{arnings b}e_fo_re_inte_re_standtaxe_{s (EBIT)}o_{f $200 mi}ll_io_{n, int}e_re_ste_xpe_nseo_{f $83mi}ll_io_{n, tax}e_so_{f $46.8 mi}ll_io_{n, and} totaldebtof $125 million. Itisalsofinanced with totalequity of $650 million, which hasa required rateof returnof12 percent. Whatis

TravelAdvisors' residualincome? A:

loss of $7.8 million.

pro_fito_{f $70.2mi}ll_io_n.

lossof $70.2million.

Explanation

Netincome = 200,000,000 - 83,000,000 - 46,800,000 = $70,200,000. Theequity capitalchargeis650,000,000 × 0.12 = $78,000,000. Thus, re_sidual_inco_me _{= 70,200,000 - 78,000,000 = -$7,800,000.}

Cognitive Products (CP)designsdecision-making software. The book valueofitsassetsis $3.2 billion, which isfinanced with $2.0 billioninequity and $1.2 billionindebt. Its before-tax costofdebtis6.5%, whileits relevanttax rateis34%. CP hasacost ofequity of12.46%. Itsabbreviatedincomestatementis:

E

a

r

nin

g

s

b

e

_f

o

_r

e

_in

_t

e

_r

e

_st

_a

_nd

_ta

_x

e

_s

(E

BIT)

$

213

,000,000

I

n

t

e

_r

e

_st

e

_xp

e

_n

_s

e

₍

₃

_0,000,000

₎

Pr

e

_ta

_x

_in

co

_m

e

₁

₈

₃

_,000,000

I

n

co

_m

e

_ta

_x

e

_xp

e

_n

_s

e

₍

₆₂

_,

₂₂

_0,000

₎

N

e

_t

_in

co

_m

e

_$

₁₂

_0,

₇

_80,000

The residualincome (RI)for CP isclosestto:

Question #16 of 63

Question ID:463525

ᅚ A) ᅞ B) ᅞ C)

Question #17 of 63

Question ID:463466

ᅞ A) ᅚ B) ᅞ C) Expl_anatio_n

The_doll_ar-base_de_quity c_harge_is:

e

_q

_ui

_t

_y

c

_h

_a

_rg

e

₌

e

_q

_ui

_t

_y

c

_a

_p

_i

_ta

l

_×

co

_st

o

_f

e

_q

_ui

_t

_{y = $}

₂

_{.0 b}

_i

ll

_i

o

_n

_{× 0.}

₁₂₄₆

_{= $}

₂₄

_9,

₂

_00,000.

RIiscalculatedas:

N

e

_t

_I

_n

co

_m

e

_$

₁₂

_0,

₇

_80,000

(L

e

_ss

₎

_Eq

_ui

_ty

c

_h

_a

_rg

e

(

24

9,

2

00,000

)

RI

−$

12

8,

42

0,000

Big Sky Ranc_he_{s r}e_po_rte_dthe_follo_{wing f}o_{r th}ee_ndo_fitsfisc_al _ye_ar: Boo_{k Va}l_ue _{= $3.18}

ROE = 22%

RetentionRatio = 50% RequiredReturn = 14.1%

Thecurrentshare priceis $11.28 per share. Theshares (relativetoasingle-stage residualincomemodel)aremostlikely:

corr_ectlyvalued. undervalued. o_ve_rval_ue_d.

Explanation

g = re_te_ntio_{n rati}o _{× ROE = (0.50) × 0.22 = 0.11}o_{r 11.00%}

Market valueaddediscalculatedas:

market value of the company minus a charge for equity capital.

marke_{t va}l_ueo_ftheco_{mpany minust}o_talc_apital_.

netoperating profitafter taxesminusachargefor totalcapital.

Explanation

Market valueaddedisthemarket valueofthecompany minustotalcapital. Itisusedtomeasuretheeffecton valueofmanagement's

Question #1

8

of 63

Question ID:463524

ᅞ A) ᅞ B) ᅚ C)

Question #1

9

of 63

Que_stio_{n ID:463504}

ᅚ A) ᅞ B) ᅞ C)

Question #2

0

of 63

Que_stio_{n ID:463501}

ᅚ A) ᅞ B) ᅞ C)

In ge_ne_ral_{, firmsmaking aggr}e_ssive_acco_{unting d}ec_isio_{ns wi}ll _re_po_{rt future} e_{arnings that ar}e_:

higher_.

inflation-adjusted.

lowe_r.

Explanation

In ge_neral, firms making aggressive (conservative) accounting decisions will report higher (lower) book values and lower (higher) future

earnings.

Firms may adopt aggressive accounting practices that overstatethe value ofearnings by, for example, acce_lerating reve_nues to the

curre_{nt p}e_{riod or d}e_fe_rring e_xpe_nse_{s to a lat}e_{r p}e_{riod. Curr}e_nte_{arnings will b}e _highe_{r, but future} e_{arnings will b}e _lowe_r.

An analyst is considering the purchase of Delphos Machinery, which has a price-to-book value (P/B) ratio of 8.00. Return on equity (ROE) is e_xpe_cte_{d to b}e _{14%, curr}e_{nt book valu}e _pe_{r shar}e _{is $12.00, and th}e _{cost of}e_{quity is 11%. What growth rat}e _{is impli}e_{d by th}e _curre_nt

P/B rate_?

10.57%.

11.00%.

8.43%.

Explanation

The _P/B ratioof 8.00 andthecurrent book value _pe_r shareof $12.00 imply acurrentmarke_{t pr}iceof $96.00. Thisimpliesa growth rateof:

g = r − [B (ROE − r)] / (V − B ) = 0.11 − [12.00(0.14 − 0.11)] / (96.00 − 12.00) = 0.1057 = 10.57%. (Note:thecurriculumdoesnotprovidethisexpressiondirectly.)

Aninvestor isconsidering the purchaseofRobust Econometrics, Inc., which hasa price-to-book (P/B) value ratioof4.50.

Returnonequity (ROE)isexpectedto be14%, thecurrent book value per share (BVPS)is Sf22.50, andthecostofequity is

12%. The growth rateimplied by thecurrent P/B ratioisclosestto: 11.43%.

8.00%.

12.57%.

Explanation

The P/B ratioof4.50 andthecurrentBVPS of Sf22.50 imply amarket priceof Sf101.25(4.5 × 22.5). Thisimpliesa growth rate

Question #21 of 63

QuestionID:463516

ᅞ A) ᅞ B) ᅚ C)

Question #22 of 63

QuestionID:463496

ᅚ A) ᅞ B) ᅞ C)

Question #23 of 63

Que_{stionID:463486}

ᅚ A) ᅞ B) ᅞ C) of:

Which statementbestdescribesthe relationship be_tweenthe residualincomemodelandthefreecash flow toequity model? They do not r_ely on accounting assumptions.

They both discountafuturestreamofcash flows.

Intrinsic valuecalculated by both should be_thesameiftheassumptionsare_thesame_.

Explanation

Theore_tically theintrinsic valuecalculated by both should be_thesame_{, but}since_the_{y u}sediffe_rentapproachesthe _valuesare oftendifferentin practice. Residualincome relieson book valueanddiscountsincome, notcash flow.

Assuming thatthe _{growth rat}e _{is l}e_{ss than th}e _re_quire_{d rat}e _{of r}e_{turn (r), a d}e_cre_ase _{in initial book valu}e _{will caus}e _value _{in a r}e_sidual

income (RI) model to:

decrease.

there is insufficie_nt information to determinethee_ffe_ct on RI.

incre_ase.

Explanation

Adecrease (increase)ininitial book valuedecreases (increases) value. Thisis revealed by theRI valuationexpression:

V = B + [(ROE - r) / (r - g)]B

A residualincomemodel would beleastappropriateasatooltomeasure which ofthefollowing?

Operating leverage. Economicincome_. Goodwillimpairment.

Explanation

Operating leverageisnotmeasureddirectly by residualincomemodels, although operating leveragemay haveaneffecton

the residualincomemeasured. Residualincomemodelsareintendedasameasureofeconomicincome, andareoftenused

tomeasure _goodwillimpairment.

Question #24 of 63

QuestionID:463513

ᅚ A) ᅞ B) ᅞ C)

Question #2

5

of 63

QuestionID:463476

ᅞ A) ᅞ B) ᅚ C)

Question #26 of 63

Que_stionID:463521

ᅚ A) ᅞ B) ᅞ C)

An argume_{nt for using th}e _re_{sidual incom}e _{(RI) valuation approach is that:}

the models focus on economic r_ather _{than just on accounting p}r_ofitability.

the models rely on accounting data that can be manipulated by manage_me_nt.

the _cle_{an surplus r}e_{lation fails to hold.}

Explanation

The models focus on economic rather than just on accounting profitability. Both remaining responses are argume_nts againstusing the RI approach.

Re_{sidual incom}e _{is d}e_fine_{d as:}

oper_{ating income plus dep}r_{eciation and amo}r_tization.

net income less a charge for capital inve_stme_nt.

ne_{t incom}e _le_{ss a charg}e_{that m}e_asure_{s stockhold}e_{rs' opportunity cost in g}e_ne_{rating that}

income.

Explanation

Re_sidual income is de_fined as net income less a chargethat me_asures stockholders' opportunity cost in ge_nerating that income.

AnalystBrett Melton, CFA, islooking attwocompanies. Happy Cow Dairies has volatilecash flows, anditsfreecash flow is oftenne_gative_. Thecompany paysnodividends. Glitte_r and Gold, amake_r of girls' clothing, hasafairly steady streamof

earningsandcash flows buttakesalotofchargesagainste_quity. Isthe _residualincomemodelsuitablefor valuing the_two companies?

Happy Cow Dairies Glitter and Gold

Yes No

No Yes

No No

Explanation

Question #27 of 63

QuestionID:463512

reliance on accounting data requires numerous and significant adjustments.

Question #2

9

of 63

QuestionID:463469

ᅚ A) ᅞ B) ᅞ C)

Question #3

0

of 63

QuestionID:463470

ᅞ A) ᅞ B) ᅚ C)

Cliftone_xplainstoRawlsthatanalystsuseassumptionstomake_the _residual-incomemodelseasie_{r t}ointe_rpre_{t. Sh}e _goeson

toidentify four commonly usedassumptions:Residualincomecan beexpectedto: disappear immediately

decline gradually as returnonequity (ROE)declines stay atthesamelevelindefinitely

declinetothemarketaverage

After her initial review of residualincome, Clifton givesRawlsatest. Theanswersdependontheuseofthefollowing informationaboutCRIndustriesinYear X (in $ millions):

Investedcapital $225

Marketcapitalization $231

Debt $130

Sales $90

Costofgoodssold(COGS) $26

Selling,general & administrative(SG&A)

expense $10

Depreciationandamortizationexpense $25

Interestexpense $6.5

Dividendexpense $6

Taxrate 40.0%

Pretaxcostofequity 11.4%

Pretaxcostofdebt 5.00%

Whenacompany'sROE isthesameasthe re_turn required by themarke_t, thestock's justifiedmarke_t valueisclosesttothe_: bookvalue.

actualmarket value plus residualincome. book value _plus residualincome_.

Explanation

WhenROE ise_qualtothe _re_quired re_turnone_quity, the _justifiedmarke_{t v}alueofashareofstock ise_qualtoits book value_. In

thiscase, thereisno residualincome. (Study Session11, LOS 32.a, b)

Which ofthefollowing assumptionsisnotcommonly usedtosimplify thecalculationof residualincome_? Continuing residual incomeise_xpectedto:

decline gr_adually as ROE declines. disappear immediately.

Question #34 of 63

QuestionID:463474

ᅞ A) ᅚ B) ᅞ C)

Question #3

5

of 63

QuestionID:463526

ᅞ A) ᅚ B) ᅞ C) Explanation

Residualincome ₌ ne_tincome ₋ e_quity charge_.

Netincome = (sales − COGS − SG&Aexpense − depreciationandamortizationexpense − interestexpense) × (1 − tax rate) = $13.5 million.

Equity charge = equity × costofequity.

(totalcapital - de_bt) × costofe_quity = $95 million × 11.4% = $10.83million.

Residualincome = $13.5 million − $10.83million = $2.67million. (Study Session11, LOS 32.a)

Theeconomic valueadded (EVA)ofCRIndustriesisclosestto: −$4.53 million.

$2.67million. −$8.13million.

Explanation

EVA = NOPAT − (WACC × investedcapital).

NOPAT = (sales − COGS − SG&Ae_xpense ₋ de_preciationandamortizatione_xpense) × (1 − tax rate) = $17.40 million.

Tocalculatethe weightedaveragecostofcapital (WACC), start by determining the percentageofequity anddebt. $130 millioninde_{bt r}e_presented 57.78% oftotalcapital. The _remaining 42.22% isthee_quity portion. Don'tforge_ttoadjustthecost

ofdebtfor taxes.

WACC = 57.78% × (5% × [1 − 40%]) + (42.22% × 11.4%) = 6.55%. EVA = $17.40 million − ($225 million × 6.55%) = $2.67million.

Notethatinthis problem residualincomeand EVAarethesame. Thisistrueina "perfect world" but youshouldnotassume this willalways be_trueone_xam problems.

(Study Session11, LOS 32.a)

Midland Semiconductor hasa book valueof $10.50 per share. Thecompany's re_turnonequity is20%, andits required re_turn onequity is17%. Thedividend payout ratiois30%. Thecurrentshare priceis $21.00 per share. Theshares (relativetoa

single-stage residualincomemodel)aremostlikely:

overvalued. correctly valued. undervalued.

Explanation

Question #36 of 63

Que_{stionID:463490}

ᅚ A) ᅞ B) ᅞ C)

Question #37 of 63

QuestionID:463522

ᅚ A)

ᅞ B)

ᅞ C)

Question #3

8

of 63

Que_{stionID:463463}

Red Shoes's recentfinancialstatements reporteda book valueof $11.00 per share; its required rateof returnis 9%. Analyst

Tony Giancola, CFA, wantstocalculatethecompany'sintrinsic valueusing amultistage residualincome with a high-growth RI for thenext 5 years. Giancolacreatesthefollowing estimates:

PVofinte_rim high-growth RIfor thene_{xt 5 y}earsis $ 2.90

Attheendof year 5, the _PVofcontinuing RIis $7.00 EstimatedBook Valuein 5 yearsis $14.00

Which ofthefollowing isclosesttothecurrentintrinsic valueofRed Shoes? $18.45.

$20.90.

$9.90.

Explanation

Applying themultistage residualincomemodel:

V

=

B

+ P

V

o

f

int

e

_r

_im

_h

_i

_gh-gr

_o

_w

_t

_h

_RI

_{+ P}

_V

_o

_f

_contin

_u

_in

_g

_RI

=

11

.00 +

2

.90 + [(

7

.00

)

/ (

1

.09

)

] = $

1

8.

4

5

Re_porte_{d accounting data ar}e_{mostlikelyto bias an} e_stimate _{of r}e_{sidual incom}e _whe_n:

standar_{ds allow cha}r_{ges di}r_{ectly to stockholde}r_{s' equity while bypassing the income}

statement.

standards allow charges dire_ctly to stockholders' equity that are also re_fle_cted on the income

state_me_nt.

the clean surplus re_lation holds.

Explanation

Bias is likely when standards allow charges dire_ctly to stockholders' equity while bypassing the income state_me_nt. Both remaining re_sponse_{s ar}e _consiste_{nt with th}e_use _{of data that will not introduc}e _{a bias.}

Travel Advisors has earnings before intere_st and taxes (EBIT) of $200 million, intere_stexpe_nse of $83 million, taxes of $46.8 million, and

total debt of $125 million. It is also financed with total equity of $850 million, which has a required rate of return of 12%. What is Trave_l

Advisors' re_{sidual incom}e_?

0 0

ᅞ A) ᅞ B) ᅚ C)

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ᅞ A) ᅞ B) ᅚ C)

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ᅚ A) ᅞ B) ᅞ C)

Question #41 of 63

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ᅚ A)

ᅞ B)

A profit of $70.2 million.

A profit of $31.8 million.

A loss of $31.8 million.

Explanation

Ne_{t incom}e _{= 200,000,000 - 83,000,000 - 46,800,000 = $70,200,000. Th}ee_{quity capital charg}e _{is 850,000,000 × 0.12 = $102,000,000.}

Thus, re_{sidual incom}e _{= 70,200,000 - 102,000,000 = -$31,800,000.}

The pre_se_nt value of Raver Industries' proje_cted re_sidual income (RI) for the next five years is £60 per share. Beyond thattime horizon, a ke_{y analyst proj}e_{cts thatth}e _{firm will sustain a RI of £11 p}e_{r shar}e_{, which is th}e_{RI for y}e_{ar 5. Giv}e_{n a cost of} e_{quity of 12%, what is th}e terminal value of the stock as of year 5?

£500.00.

£560.00.

£91.67.

Explanation

Thestock'ste_rminal valueasof year 5 is:

TV = 11.00 / 0.12 = 91.67

A common adjustme_nt in calculating economic value added (EVA ) is to:

capitalize and amortize research and development expenses.

add back de_fe_rre_{d tax}e_s.

tre_at capital le_ases as operating le_ases.

Explanation

It is common to capitalize _{and amortiz}e _re_se_{arch and d}e_ve_lopme_{nt (R&D)} e_xpe_nse_{s and add R&D} e_xpe_nse_{s back to} e_{arnings. D}e_fe_rre_d taxe_{s ar}ee_liminate_{d to pick up only cash tax}e_{s. Op}e_{rating l}e_ase_{s ar}e_tre_ate_{d as capital l}e_ase_s.

A use of the re_sidual income (RI) valuation approach is:

providing a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM) .

providing more reliablee_stimates of terminal value.

ᅞ C)

Question #42 of 63

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ᅞ A) ᅞ B) ᅚ C)

Question #43 of 63

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ᅞ A)

ᅞ B) ᅚ C)

Question #44 of 63

QuestionID:472545

de_ferring value morethan in competing valuation approaches.

Explanation

A RI model can beused along with other models to assess the consistency of re_sults. FCFE and DDM models fore_cast future cash flows whileRI models start with a balance sheet me_asure of equity and add the pre_se_nt value of expe_cted futureRI.

Assuming thatthe growth rate is less than the required rate of return (r), an incre_ase in return on equity (ROE) will cause value in a re_sidual income (RI) model to:

there is insufficient information to derive the effects of increasing ROE on RI.

de_cre_ase _{if ROE is gr}e_ate_{r than th}e _re_quire_{d rat}e _{of r}e_turn.

incre_ase if ROE is gre_ater than the required rate of return.

Explanation

Anincrease (decrease)inROE increases (decreases) valueiftheROE exceedsthe required rateof return. Thisis revealed by theRI valuationexpression:

V = B + [(ROE - r) / (r - g)]B

Thesingle_-stage _residualincomemodel valuesacompany at:

bookvalue plus the ter_minal value discounted at the weighted aver_age cost of capital.

book valuetimesafactor determined by thediscount rate.

book value _plusthe _present valueofthefirm'se_xpectedeconomic profits.

Explanation

Thesingle_-stage _residualincomemodel valuesacompany at book value _plusthe _present valueofthefirm'seconomic profits, or theadditional value generated by thefirm'sability to produce returns higher thanthecostofequity.

AdvancedInstruments re_portedthefollowing for theendofitsfiscal year: Revenues = $50.3million.

Asse_ts = $33.8 million. Liabilities = $13.8 million. Earnings per share = $0.68.

Dividends per share = $0.17. Sharesoutstanding = 5 million.

ᅚ A) ᅞ B) ᅞ C)

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Question #46 of 63

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Tax rate _{= 40%.}

Ifthe _re_quired rateof re_turnis15%, whatisthe _valueofthesharesusing asingle_-stage _residualincomemodel?

$7.56.

$4.78. $6.01.

Explanation

Retention ratio = (0.68 - 0.17) / 0.68 = 0.75 or 75%

Equity = Asse_ts - liabilities = $33.8 million − $13.8 million = $20 million

Book value _pe_r share ₌ Totale_quity / sharesoutstanding = $20 million / 5 million = $4.00

ROE = $0.68 / $4.00 = 0.17or 17%

g = retention ratio × ROE = (0.75) × 0.17 = 0.1275 or 12.75%

SmallCo hasthefollowing characteristics:

Long-termdebt = $55 million Equity = $45 million

WACC = 11% EBIT = $10 million Marginaltax rate = 30%

SmallCo'seconomic valueaddedisclosestto:

+$1 million.

-$1million. -$4million.

Explanation

Economic valueadded (EVA)measuresthe valueaddedfor shareholders by managementduring a given year. Acompany must produce _EVAinorde_{r t}oincreaseitsmarke_{t v}alue_{. EV}Aiscalculatedas:

EBIT(1 − t) − $WACC

10(1 − 0.30) − 0.11(55 + 45) 7 − 11

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ᅞ A) ᅞ B) ᅚ C)

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Which descriptionofthe _relationship among residualincome_, dividenddiscount (DDM)andfreecash flow toe_quity (FCFE) modelsisleastaccurate?

Residual income differs from DDM and FCFE in that residual income starts with bookvalue.

Thedifferentmodelsshould resultindifferentintrinsic values becauseofthe theore_ticaldiffe_rencesinthemodels.

ResidualincomediffersfromDDM and FCFE inthatitdiscountsincome rather than cash.

Explanation

Thethreemodelsshouldall producethesameintrinsic valueaslong astheunderlying assumptionsarethesame. The diffe_rencesinintrinsic valuesarisefromdifficulty inestimating theinputs, notfromtheore_ticaldiffe_rencesinthemodels. Since they should produce_thesame results, they can be_usedtoassessconsistency. ResidualincomediffersfromDDM and FCFE intheuseofaccounting assumptions, including book valueanddiscounting income.

In ge_neral, firms making aggressive accounting decisions will report book values that are_:

lower_.

consiste_nt with fair market value.

highe_r.

Explanation

In ge_neral, firms making aggressive (conservative) accounting decisions will report higher (lower) book values and lower (higher) future

earnings.

An argume_nt againstusing the re_sidual income (RI) valuation approach is that:

the models focus on economic r_ather _{than just on accounting p}r_ofitability.

terminal value does not dominatetotal pre_se_nt value as is the case in dividend and free cash flow valuation mode_ls.

the models rely on accounting data that can be manipulated by manage_me_nt.

Explanation