LOS e: Explain the relationship between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals.

Q1. In a single-stage residual income model for a firm with return on equity (ROE) greater than the required rate of return, which statement is least accurate?

A)   Market value will be greater than book value.

B)   Free cash flow to equity will be positive.

C)   The justified price-to-book value (P/B) ratio will be greater than one.

Q2. Among the various price multiples, the residual income model is most closely linked to which of the following?

A)   Price to book value (P/B).

B)   Price to free cash flow (P/FCF).

C)   Price to earnings (P/E).

Q3. Assuming that the growth rate is less than the required rate of return (r), a decrease in initial book value will cause value in a residual income (RI) model to:

A)   increase.

B)   decrease.

C)   there is insufficient information to determine the effect on RI.

LOS e: Explain the relationship between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals. fficeffice" />

Q1. In a single-stage residual income model for a firm with return on equity (ROE) greater than the required rate of return, which statement is least accurate?

A)   Market value will be greater than book value.

B)   Free cash flow to equity will be positive.

C)   The justified price-to-book value (P/B) ratio will be greater than one.

Correct answer is B)

In a single-stage residual income model with ROE greater than the required rate of return, justified P/B will be greater than one and market value will be greater than book. There is no clear relationship with free cash flow to equity.

Q2. Among the various price multiples, the residual income model is most closely linked to which of the following?

A)   Price to book value (P/B).

B)   Price to free cash flow (P/FCF).

C)   Price to earnings (P/E).

Correct answer is A)

The residual income model is most closely linked to P/B because justified P/B is directly linked to expected residual future income.

Q3. Assuming that the growth rate is less than the required rate of return (r), a decrease in initial book value will cause value in a residual income (RI) model to:

A)   increase.

B)   decrease.

C)   there is insufficient information to determine the effect on RI.

Correct answer is B)

A decrease (increase) in initial book value decreases (increases) value. This is revealed by the RI valuation expression:

V₀ = B₀ + [(ROE – r) / (r – g)]B₀