LOS b: Discuss the uses of residual income models.

Q1. Which of the following is the most appropriate tool to measure managerial effectiveness, goodwill impairment, and equity value?

A)   Gordon growth model.

B)   Free cash flow to the firm.

C)   Residual income.

Q2. A residual income model would be least appropriate as a tool to measure which of the following?

A)   Economic income.

B)   Operating leverage.

C)   Goodwill impairment.

Q3. The residual income approach is appropriate when:

A)   a firm does not pay dividends or the payments are too volatile to be sufficiently predictable.

B)   a firm pays high dividends that are quite stable.

C)   the clean surplus accounting relation is violated significantly.

LOS b: Discuss the uses of residual income models. fficeffice" />

Q1. Which of the following is the most appropriate tool to measure managerial effectiveness, goodwill impairment, and equity value?

A)   Gordon growth model.

B)   Free cash flow to the firm.

C)   Residual income.

Correct answer is C)

Residual income is commonly used to measure managerial effectiveness, goodwill impairment and equity value. The Gordon Growth Model (GGM) would not be appropriate in instances where the underlying assumptions (such as stable growth in perpetuity) do not apply. Free cash flow to the firm and price to sales would often not be appropriate tools to measure goodwill impairment.

Q2. A residual income model would be least appropriate as a tool to measure which of the following?

A)   Economic income.

B)   Operating leverage.

C)   Goodwill impairment.

Correct answer is B)

Operating leverage is not measured directly by residual income models, although operating leverage may have an effect on the residual income measured. Residual income models are intended as a measure of economic income, and are often used to measure goodwill impairment.

Q3. The residual income approach is appropriate when:

A)   a firm does not pay dividends or the payments are too volatile to be sufficiently predictable.

B)   a firm pays high dividends that are quite stable.

C)   the clean surplus accounting relation is violated significantly.

Correct answer is A)

The residual income approach is appropriate when a firm does not pay dividends or the payments are too volatile to be sufficiently predictable. It is not appropriate when the clean surplus accounting relation is violated significantly. A firm that pays high dividends that are quite stable is also a poor candidate for the approach.

thanks