Robert Davenport case Scenario
Robert Davenport, CFA, is reviewing the report on Fashion Wire that his firm issued last year.
Fashion Wire is a U.S. company operating in the appliance industry. Selected data from the 31 December 2008 balance sheet and the 2008 income statement are shown in Exhibits 1 and 2. The data from the financial statements were adjusted as follows:
? Assets and liabilities are at fair value.
? Depreciation expense reflects the economic obsolescence of assets.
? Non-recurring items have been removed.
? Clean surplus accounting applies.
Davenport also gathers the following information:
? The current stock price is $10.00 per share.
? The required return on equity capital (re) is 12.0 percent.
? The company’s before-tax and after-tax weighted average cost of capital (WACC) respectively are 11.8 percent and 10.1 percent. Davenport is deciding whether the next report on Fashion Wire should include residual income and related measures of valuation. He first wants to support his belief that shareholders are better informed with the economic value added (EVA) measure than with traditional net income measure. He also wants to show how residual income is calculated.
Fashion Wire has already announced several new projects that will greatly increase the size of the company. Davenport has decided to use value-based measures, specifically EVA, to illustrate his concern that shareholder value for Fashion Wire may decrease despite the new projects and larger company size.
Dev Raj, Davenport’s supervisor, presents the following scenario for Rajasthan Appliances, a Fashion Wire competitor, and asks him to provide a valuation of the competitor’s stock using a residual income valuation model:
? Return on equity (ROE) is 14 percent and the growth rate of earnings is 7 percent; both figures are assumed to remain constant indefinitely.
? The book value per share is $12.00.
? The cost of equity capital (re) is 12.5 percent. The before-tax and after-tax weighted average cost of capital (WACC) are 11.3 percent and 10.6 percent, respectively.
? The market value per share is $14.00.
Further, Raj states that residual income models are appropriate even for valuing firms with the following characteristics:
(1) Firms where cash flows are unpredictable.
(2) Firms that do not pay dividends or when dividends are not predictable. In responding to Raj, Davenport expresses his concern regarding the differences in accounting practices that could result in misleading valuations when using residual income models.
Specifically, Davenport makes the following two statements:
1. The residual income model will underestimate the value of the company if it chooses to capitalize an expenditure rather than expensing it.
2. Accounting for changes in the value of investments considered to be “available-for-sale” biases the valuation by incorrectly stating both book value of equity and ROE.
In closing, Raj asks Davenport to take the above accounting issues into consideration when valuing companies using residual income models.
37. The best support for Davenport’s belief about the economic value added (EVA) measure and the traditional net income measure is that EVA:
A. uses cash flow data while net income uses accounting data.
B. deducts the dollar cost of capital from the net operating profit after taxes while net income does not.
C. deducts the interest charge on debt from the net operating profit after taxes while net income does not.
Answer: B
“Capital Budgeting,” John D. Stowe, CFA, and Jacques R. Gagné, CFA 2009 Modular Level II, Volume 3, pp. 64-66 “Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 529-534 Study Session 8-28-i, 12-45-a, b Differentiate among, and evaluate a capital project using, the following valuation models: economic profit (EP), residual income, and claims valuation.
Calculate and interpret residual income and related measures (e.g., economic value added and market value added).
Discuss the uses of residual income models.
The better information provided by EVA over net income comes from the fact that EVA is computed as NOPAT net of cost of capital where as net income does not adjust for the cost of capital.
38. Fashion Wire’s residual income in 2008 is closest to:
A. -$168.
B. $ 0.
C. $154.
Answer: B
“Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 529-530 Study Session 12-45-a
Calculate and interpret residual income and related measures (e.g., economic value added and market value added).
Residual Income = Net Income – (cost of equity capital x equity capital) = 975 – (0.12 x 8,125) = 0
39. Which of the following results from value-based metrics would best support Davenport’s concern about Fashion Wire’s shareholder value, new projects, and larger company size?
A. Dollar cost of total capital > Net operating profit after taxes.
B. Return on equity (ROE) > return on equity capital required by investors (re).
C. Strategic investments that are not expected to generate a return immediately.
Answer: A
“Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 529-534 Study Session 12-45-a
Calculate and interpret residual income and related measures (e.g., economic value added and market value added).
EVA = NOPAT – (%C x TC); where %C is the cost of capital and TC is total capital.
Therefore, when the dollar cost of capital (%C x TC) > NOPAT, EVA < 0.
40. Based on the scenario provided to Davenport by his supervisor, the intrinsic value of Rajasthan Appliances’ stock using the residual income valuation model is closest to:
A. $15.27.
B. $19.53.
C. $23.33.
Answer: A
“Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 542-544 Study Session 12-45-f Calculate and interpret the intrinsic value of a share of common stock using a single-stage (constant growth) residual income model.
41. In regard to the appropriateness of firm characteristics for using residual income models, Raj is most accurate with respect to:
A. dividends only.
B. cash flows only.
C. both cash flows and dividends.
Answer: C
“Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 552-553 Study Session 12-45-l
Justify the selection of the residual income model for equity valuation, given characteristics of the company being valued.
Residual income valuation models are appropriate when a company does not pay dividends, or its dividends are not predictable, and they are also appropriate when a firm’s cash flows are unpredictable.
42. In regard to Davenport’s response to Raj, it is most accurate to state that he is correct with respect to:
A. statement 1 but not 2.
B. statement 2 but not 1.
C. neither statement 1 nor 2.
Answer: C
“Residual Income Valuation,” John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.
Pinto, CFA, and Dennis W. McLeavey, CFA 2009 Modular Level II, Volume 4, pp. 553-555 Study Session 12-45-m
Discuss the major accounting issues in applying residual income models. Davenport is incorrect in regard to both of his statements. If a company chooses to capitalize an expenditure rather than expensing it, the model overestimates the value. Accounting for changes in the value of investments considered to be “available-for-sale” biases the valuation by incorrectly stating ROE but not the book value of equity.
|
发表于 2009-7-1 15:15
| 
