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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.

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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.

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A use of the residual income (RI) valuation approach is:

A) deferring value more than in competing valuation approaches.

B) providing more reliable estimates of terminal value.

C) providing a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM) .

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A RI model can be used along with other models to assess the consistency of results. FCFE and DDM models forecast future cash flows while RI models start with a balance sheet measure of equity and add the present value of expected future RI.

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An argument against using the residual income (RI) valuation approach is that:

A) terminal value does not dominate total present value as is the case in dividend and free cash flow valuation models.

B) the models rely on accounting data that can be manipulated by management.

C) the models focus on economic rather than just on accounting profitability.

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An argument against using the RI approach is that the models rely on accounting data that can be manipulated by management. Both remaining responses are arguments in favor of the approach.

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The residual income approach is appropriate when:

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

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

C) the clean surplus accounting relation is violated significantly.

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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.

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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.

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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.

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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

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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.

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

A) Book-value estimates are not reliable.

B) The forecast of terminal value is not reliable.

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

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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.

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Reported accounting data are most likely to bias an estimate of residual income when:

A) the clean surplus relation holds.

B) standards allow charges directly to stockholders' equity while bypassing the income statement.

C) standards allow charges directly to stockholders' equity that are also reflected on the income statement.

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Bias is likely when standards allow charges directly to stockholders’ equity while bypassing the income statement. Both remaining responses are consistent with the use of data that will not introduce a bias.

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general, firms making aggressive accounting decisions will report future earnings that are:

A) lower.

B) higher.

C) inflation-adjusted.

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In general, firms making aggressive (conservative) accounting decisions will report higher (lower) book values and lower (higher) future earnings.
Firms may adopt aggressive accounting practices that overstate the value of earnings by, for example, accelerating revenues to the current period or deferring expenses to a later period. Current earnings will be higher, but future earnings will be lower.