Q4. Which of the following regarding the statements Clifton made about the usefulness of residual-income valuation is most accurate? Clifton is correct in regard to:

A)   Reasons 1, 2, and 4, but incorrect in regard to Reason 3.

B)   Reasons 1 and 2, but incorrect in regard to Reasons 3 and 4.

C)   Reason 4, but incorrect in regard to Reasons 1, 2 and 3.

Q5. Which of the following scenarios represents a violation of the clean surplus relationship?

A)   Unusual charges against income are not charged against equity.

B)   A company stops paying dividends suddenly.

C)   The market value of securities held for sale changes.

Q6. The residual income of CR Industries is closest to:

A)   ?$15.45 million.

B)   ?$0.63 million.

C)   ?$4.23 million.

Q7. The economic value added (EVA) of CR Industries is closest to:

A)   $2.66 million.

B)   ?$8.13 million.

C)   ?$4.53 million.

Q8. Geremiah Analytics provides litigation consulting services to the intellectual property industry. They specialize in patent infringement liability and software valuation. Mariah Hofstedt, CFO of Geremiah, projects that the firm will earn $3 million pre-tax income this year. Additional selected financial data on Geremiah are presented below.

Table 1: Selected Financial Data for Geremiah Analytics

Hofstedt has not been happy with the firm’s financial performance. She would like to increase return on equity (ROE) and improve revenue growth, and is considering various ways to deploy Geremiah’s cash flow in order to meet these two goals. One possibility is using some of Geremiah’s cash flow to make a strategic acquisition.

Hofstedt has been looking at a smaller boutique firm, Logiciels LaMarre, which provides consulting services to the software industry. Hofstedt and a Geremiah Analytics valuation team have performed a preliminary valuation on Logiciels LaMarre using a free cash flow to equity (FCFE) model. However, Theodore LaMarre, CEO of Logiciels LaMarre, is not pleased with the resultant valuation that Geremiah has placed on his firm.

Rather than argue about the inputs of the free cash flow (FCF) model, LaMarre takes the position that FCFE is an inappropriate model for valuing Logiciels LaMarre. He cites the firm’s rapid growth and resultant need for capital investment as reasons that valuing the firm on projections of FCFE is not reliable.

LaMarre wants Geremiah to value Logiciels LaMarre using the residual income approach. LaMarre tells Hofstedt, “Valuation with residual income models is less sensitive to forecast error than valuation with FCFE models because residual income valuations rely on current book value.”

Hofstedt feels substantial disagreement with LaMarre’s approach on a variety of grounds. She views his arguments as negotiating ploys to raise the acquisition price of his firm, and does not agree with his assessment of the FCF valuation her team has developed. On a theoretical basis, Hofstedt considers the residual income approach an inappropriate tool for valuing a firm like Logiciels LaMarre. Hofstedt tells LaMarre, “It’s not appropriate to use a residual income model to value Logiciels LaMarre because the impact of your currency translation gains and losses in shareholder equity causes the clean surplus accounting relation to be violated.”

LaMarre ignores her concern and persists in his argument. He asserts, “The fact that our terminal value can be calculated with a high degree of certainty makes the use of a residual value model more appropriate than use of a FCFE model.” Hofstedt counters that the residual income approach is not in LaMarre’s interest. She points out, “Value tends to be recognized later in a residual income approach than in a FCFE approach.”

There is, however, one point on which LaMarre and Hofstedt agree. They both recognize that competitive forces in the industry will drive the current high ROE of Logiciels LaMarre down to the cost of equity capital over time. Hofstedt concludes, “Given the assumption of a decline in ROE, we should use a persistence factor between zero and one.” LaMarre disagrees, saying, “The assumption about ROE means that the present value of the continuing residual income at Logiciels LaMarre is the current residual income divided by the cost of equity capital.”

Regarding their statements about the impact of the clean surplus accounting relation and terminal value on when it is appropriate to use a residual income model, who is correct?

          LaMarre                                Hofstedt

A)   Correct                                 Incorrect

B)   Correct                                 Correct

C)   Incorrect                               Correct

Q9. A higher dividend payout ratio and higher ROE would most likely have what impact on Logiciels LaMarre’s persistence factor?

    ROE       Dividend payout ratio

A)  Lower                                      Lower

B)  Lower                                      Higher

C)  Higher                                     Lower

Q10. Regarding their statements about the forecast error in residual income models and when they recognize value, who is correct?

         LaMarre                                Hofstedt

A)   Correct                                 Incorrect

B)   Correct                                 Correct

C)   Incorrect                               Incorrect

thanks