LOS d: Discuss the fundamental determinants or drivers of residual income.

Q1. Assuming that the growth rate is less than the required rate of return (r), an increase in return on equity (ROE) will cause value in a residual income (RI) model to:

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

B)   increase if ROE is greater than the required rate of return.

C)   decrease if ROE is greater than the required rate of return.

Q2. Professor Cliff Webley made the following statements in his asset-valuation class:

Statement 1: “Over time, a company’s residual income growth tends to approach the industry average.”

Statement 2: “If actual return on equity equals required return on equity, the residual income model sets the company’s proper market value equal to its book value.”

Statement 3: “The single-stage residual income model should give you the same valuation as the Gordon Growth model.”

Which of Webley’s statements is least accurate?

A)   Statement 2.

B)   Statement 3.

C)   Statement 1.

Q3. The single-stage residual income model values a company at:

A)   book value times a factor determined by the discount rate.

B)   book value plus the terminal value discounted at the weighted average cost of capital.

C)   book value plus the present value of the firm’s expected economic profits.

Correct answer is C)

LOS d: Discuss the fundamental determinants or drivers of residual income. fficeffice" />

Q1. Assuming that the growth rate is less than the required rate of return (r), an increase in return on equity (ROE) will cause value in a residual income (RI) model to:

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

B)   increase if ROE is greater than the required rate of return.

C)   decrease if ROE is greater than the required rate of return.

Correct answer is B)

An increase (decrease) in ROE increases (decreases) value if the ROE exceeds the required rate of return. This is revealed by the RI valuation expression:

V₀ = B₀ + [(ROE – r) / (r – g)]B₀

Q2. Professor Cliff Webley made the following statements in his asset-valuation class:

Statement 1: “Over time, a company’s residual income growth tends to approach the industry average.”

Statement 2: “If actual return on equity equals required return on equity, the residual income model sets the company’s proper market value equal to its book value.”

Statement 3: “The single-stage residual income model should give you the same valuation as the Gordon Growth model.”

Which of Webley’s statements is least accurate?

A)   Statement 2.

B)   Statement 3.

C)   Statement 1.

Correct answer is C)

Over time, a company’s residual income growth tends to approach zero. It is unlikely that an industry’s average growth rate is zero, so Statement 1 is questionable. The other two statements are accurate.

Q3. The single-stage residual income model values a company at:

A)   book value times a factor determined by the discount rate.

B)   book value plus the terminal value discounted at the weighted average cost of capital.

C)   book value plus the present value of the firm’s expected economic profits.

Correct answer is C)

The single-stage residual income model values a company at book value plus the present value of the firm’s economic profits, or the additional value generated by the firm’s ability to produce returns higher than the cost of equity.

thanks