LOS l: Justify the selection of the residual income model for equity valuation, given characteristics of the company being valued.

Q1. The residual income approach is appropriate when:

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

B)   the clean surplus accounting relation is violated significantly.

C)   expected free cash flows are negative for the foreseeable future.

Q2. The residual income approach is NOT appropriate when:

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

B)   the clean surplus accounting relation is violated significantly.

C)   expected free cash flows are negative for the foreseeable future.

Q3. Analyst Brett Melton, CFA, is looking at two companies. Happy Cow Dairies has volatile cash flows, and its free cash flow is often negative. The company pays no dividends. Glitter and Gold, a maker of girls’ clothing, has a fairly steady stream of earnings and cash flows but takes a lot of charges against equity. Is the residual income model suitable for valuing the two companies?

         Happy Cow Dairies         Glitter and Gold

A)     No                                     Yes

B)    Yes                                      No

C)    No                                       No

Q4. Which of the following characteristics of a company would make it unsuitable for residual income valuation analysis?

A)   The forecast of terminal value is not reliable.

B)   Free cash flows are negative and likely to remain so for some time.

C)   Book-value estimates are not reliable.

LOS l: Justify the selection of the residual income model for equity valuation, given characteristics of the company being valued. fficeffice" />

Q1. The residual income approach is appropriate when:

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

B)   the clean surplus accounting relation is violated significantly.

C)   expected free cash flows are negative for the foreseeable future.

Correct answer is C)

The residual income approach is appropriate when expected free cash flows are negative for the foreseeable future. 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.

Q2. The residual income approach is NOT appropriate when:

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

B)   the clean surplus accounting relation is violated significantly.

C)   expected free cash flows are negative for the foreseeable future.

Correct answer is B

The residual income approach is not appropriate when the clean surplus accounting relation is violated significantly. Both remaining responses describe circumstances in which the approach is appropriate.

Q3. Analyst Brett Melton, CFA, is looking at two companies. Happy Cow Dairies has volatile cash flows, and its free cash flow is often negative. The company pays no dividends. Glitter and Gold, a maker of girls’ clothing, has a fairly steady stream of earnings and cash flows but takes a lot of charges against equity. Is the residual income model suitable for valuing the two companies?

         Happy Cow Dairies         Glitter and Gold

A)     No                                     Yes

B)    Yes                                      No

C)    No                                       No

Correct answer is B)

Residual income models work for companies with no dividends and volatile or negative cash flows. They do not work, however, when the clean surplus relation does not hold, as is the case when companies take charges against equity.

Q4. Which of the following characteristics of a company would make it unsuitable for residual income valuation analysis?

A)   The forecast of terminal value is not reliable.

B)   Free cash flows are negative and likely to remain so for some time.

C)   Book-value estimates are not reliable.

Correct answer is C)         

Residual income models can handle negative free cash flows and poor forecasts for terminal value. However, poor book-value estimates render the statistic less useful.