invic

Which statement best describes the relationship between the residual income model and the free cash flow to equity model?

A) Intrinsic value calculated by both should be the same if the assumptions are the same.

B) They do not rely on accounting assumptions.

C) They both discount a future stream of cash flows.

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Theoretically the intrinsic value calculated by both should be the same, but since they use different approaches the values are often different in practice. Residual income relies on book value and discounts income, not cash flow.

invic

Which description of the relationship among residual income, dividend discount (DDM) and free cash flow to equity (FCFE) models is least accurate?

A) Residual income differs from DDM and FCFE in that residual income starts with book value.

B) The different models should result in different intrinsic values because of the theoretical differences in the models.

C) Residual income differs from DDM and FCFE in that it discounts income rather than cash.

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The three models should all produce the same intrinsic value as long as the underlying assumptions are the same. The differences in intrinsic values arise from difficulty in estimating the inputs, not from theoretical differences in the models. Since they should produce the same results, they can be used to assess consistency. Residual income differs from DDM and FCFE in the use of accounting assumptions, including book value and discounting income.

invic

Which of the following statements least accurately explains the relationship between the residual income (RI) model, the dividend discount model (DDM), and free cash flow to equity (FCFE):

A) All the models discount future cash flows or income at the required rate of return.

B) FCFE models use historical cash flows.

C) RI models use an equity value from the balance sheet plus the present value of expected future residual income.

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In theory, the same value or total present value should be derived using expected dividends, expected FCFE, or book value plus expected residual income if the underlying assumptions are the same. However, the recognition of value is different because FCFE and DDM models forecast future cash flows, while residual income models start with a balance sheet measure of equity and add the present value of expected future residual income. A residual income model can be used along with other models to assess the consistency of results.

invic

The present value of Forman Electronics’ projected residual income (RI) for the next five years is £80 per share. Beyond that time horizon a key analyst projects that the firm will sustain a RI of £17 per share, which is the RI for year 5. Given a cost of equity of 13%, what is the terminal value of the stock as of year 5?

A) £130.77.

B) £500.00.

C) £19.96.

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The stock’s terminal value as of year 5 is:

TV = 17.00 / 0.13 = 130.77

invic

The present value of GB Industries’ projected residual income (RI) for the next five years is 70 per share. Beyond that time horizon, a key analyst projects that the firm will sustain a RI of 15 per share, which is the RI for year 5. Given a cost of equity of 12%, what is the terminal value of the stock as of year 5?

A) £500.00.

B) £560.00.

C) £125.00.

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The stock’s terminal value as of year 5 is:

TV = 15.00/0.12 = 125.00

invic

The present value of Raver Industries’ projected residual income (RI) for the next five years is £60 per share. Beyond that time horizon, a key analyst projects that the firm will sustain a RI of £11 per share, which is the RI for year 5. Given a cost of equity of 12%, what is the terminal value of the stock as of year 5?

A) £500.00.

B) £560.00.

C) £91.67.

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The stock’s terminal value as of year 5 is:

TV = 11.00 / 0.12 = 91.67

invic

A common assumption regarding continuing residual income (RI) is that RI:

A) falls to the average industry level.

B) declines to zero as return on equity (ROE) drops to the cost of equity over time.

C) manifests a generally increasing trend indefinitely.

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It is common to assume that RI declines to zero as ROE drops to the cost of equity over time. Other assumptions analysts may make include RI continues indefinitely at a positive level or RI reflects a decline in ROE to a long-run average level.

invic

Continuing residual income is defined as the:

A) permanent as opposed to the transitory part of residual income.

B) residual income that forces the net present value to zero.

C) residual income that is expected beyond the initial forecast time horizon.

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Continuing residual income is defined as the residual income that is expected beyond the initial forecast time horizon. It comes into play when RI is forecast for a defined time horizon and a terminal value based on continuing RI is estimated at the end of that time frame.

hariRaj

An analyst is considering the purchase of Delphos Machinery, which has a price-to-book value (P/B) ratio of 8.00. Return on equity (ROE) is expected to be 14%, current book value per share is $12.00, and the cost of equity is 11%. What growth rate is implied by the current P/B rate?

A) 10.57%.

B) 8.43%.

C) 11.00%.

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The P/B ratio of 8.00 and the current book value per share of $12.00 imply a current market price of $96.00. This implies a growth rate of:
g = r − [B0(ROE − r)] / (V0 − B0) = 0.11 − [12.00(0.14 − 0.11)] / (96.00 − 12.00) = 0.1057 = 10.57%.
(Note: the curriculum does not provide this expression directly.)

hariRaj

An investor is considering the purchase of Microscopics, which has a price to book value (P/B) ratio of 4.00. Return on equity (ROE) is expected to be 12%, current book value per share is $12.00, and the cost of equity is 10%. What growth rate is implied by the current P/B rate?

A) 9.33%.

B) 10.00%.

C) 0.67%.

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The P/B ratio of 4.00 and the current book value per share of $12.00 imply a current market price of $48.00. This implies a growth rate of:
g = r – [{B0(ROE – r)} / {V0 – B0}] = 0.10 – [{12.00(0.12 – 0.10)} / {48.00 – 12.00}] = 0.0933 = 9.33%.
Note that the reading in the curriculum does not provide this expression directly.