hariRaj

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

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

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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

hariRaj

Krieger String & Twine expects to generate a return on equity (ROE) of 13.6% in each of the next five years. The required ROE is 8.7%. Current book value is $12.40 per share and the firm pays no dividends. Krieger previously assumed residual income falls to zero immediately after five years, but has now decided to recalculate its estimated value using a persistence factor of 35%. The difference between the new valuation and the old one is closest to:

A) $0.32 per share.

B) $0.16 per share.

C) $0.64 per share.

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To answer this question, we need to establish the residual values using the following equations:
Earnings = prior year book value × ROE
Equity charge = prior year book value × required ROE
Residual income = earnings − equity charge
Here is a table containing the relevant values.

Year	Earnings (ROE = 13.60%)	Book Value	Equity Charge (Required ROE = 8.70%)	Residual Income	PV of Residual Income
0		$12.40
1	$1.69	$14.09	$1.08	$0.61	$0.56
2	$1.92	$16.00	$1.23	$0.69	$0.58
3	$2.18	$18.18	$1.39	$0.78	$0.61
4	$2.47	$20.65	$1.58	$0.89	$0.64
5	$2.81	$23.46	$1.80	$1.01	$0.67

Company value = $12.40 + the sum of the residual incomes
Assuming residual value drops to zero after year five, the company is valued at $15.46 per share.
Now, we modify the model to reflect the persistence factor of 35%. The only value that persistence factor effects is the terminal value. Instead of discounting the Year 5 residual income by 1 + required ROE, we discount it by 1 + required ROE − persistence factor. The new values are as follows:

	Book Value	Year 1	Year 2	Year 3	Year 4/5
Value	$12.40	$0.56	$0.58	$0.61	$1.62

For a total value of $15.78 per share, or $0.32 higher than the original value.

hariRaj

If a multistage residual income model does not consider a persistence factor, the analyst using the model is most likely assuming that residual income:

A) falls to an industry norm.

B) falls to zero over time.

C) falls to zero immediately.

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The assumption that residual income declines to a long-run level in a mature industry allows for the use of a simpler formula that does not require a persistence factor. Both of the other assumptions listed require an equation that uses the persistence factor.

hariRaj

Brown Manufacturing’s recent financial statements reported a book value of $9.50 per share; its required rate of return is 10%. Analyst Tony Giancola, CFA, wants to calculate the company’s intrinsic value using a multistage residual income with a high-growth RI for the next 5 years. Giancola creates the following estimates: PV of interim high-growth RI for the next 5 years is $3.10 At the end of year 5, the PV of continuing RI is $10.00 Estimated Book Value in 5 years is $25.00
Which of the following is closest to the current intrinsic value of Brown Manufacturing?

A) $18.81.

B) $22.60.

C) $13.10.

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Applying the multistage residual income model:

V0 = B0 + PV of interim high-growth RI + PV of continuing RI
= 9.50 + 3.10 + [(10.00) / (1.10)5] = $18.81

hariRaj

Red Shoes’s recent financial statements reported a book value of $11.00 per share; its required rate of return is 9%. Analyst Tony Giancola, CFA, wants to calculate the company’s intrinsic value using a multistage residual income with a high-growth RI for the next 5 years. Giancola creates the following estimates: PV of interim high-growth RI for the next 5 years is $ 2.90 At the end of year 5, the PV of continuing RI is $7.00 Estimated Book Value in 5 years is $14.00
Which of the following is closest to the current intrinsic value of Red Shoes?

A) $18.45.

B) $20.90.

C) $9.90.

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Applying the multistage residual income model:

V0 = B0 + PV of interim high-growth RI + PV of continuing RI
= 11.00 + 2.90 + [(7.00) / (1.09)5] = $18.45

hariRaj

Creative Gardening is expected to have a return on equity (ROE) of 13% for the next five years and 10% thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $7.50 per share and its required rate of return is 10%. The premium over book value at the end of five years is expected to be 30%. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $1.10. The projected ending book value in year 5 is $13.83. What is the value of Creative Gardening using these inputs?

A) $11.18.

B) $13.83.

C) $8.60.

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Applying the finite horizon residual income valuation model:

V0 = B0 + sum of discounted RIs + discounted premium

= 7.50 + 1.10 + [(0.30)(13.83)/(1.10)5] = $11.18

hariRaj

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

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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.

hariRaj

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

A) Economic income.

B) Goodwill impairment.

C) Operating leverage.

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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

hariRaj

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

A) Residual income.

B) Gordon growth model.

C) Free cash flow to the firm.

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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.

hariRaj

A common adjustment in calculating economic value added (EVA®) is to:

A) add back deferred taxes.

B) capitalize and amortize research and development expenses.

C) treat capital leases as operating leases.

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It is common to capitalize and amortize research and development (R&D) expenses and add R&D expenses back to earnings. Deferred taxes are eliminated to pick up only cash taxes. Operating leases are treated as capital leases.