LOS h, (Part 1): Explain continuing residual income and list the common assumptions regarding continuing residual income.

Q1. Continuing residual income is defined as the:

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

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

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

Q2. A common assumption regarding continuing residual income (RI) is that RI:

A)   falls to the average industry level.

B)   manifests a generally increasing trend indefinitely.

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

LOS h, (Part 1): Explain continuing residual income and list the common assumptions regarding continuing residual income. fficeffice" />

Q1. Continuing residual income is defined as the:

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

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

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

Correct answer is B)

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.

Q2. A common assumption regarding continuing residual income (RI) is that RI:

A)   falls to the average industry level.

B)   manifests a generally increasing trend indefinitely.

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

Correct answer is C)

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.