invic

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.

invic

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.

invic

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.

invic

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.

invic

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.

invic

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.

invic

Big Sky Ranches reported the following for the end of its fiscal year:

• Book Value = $3.18
• ROE=22%
• Retention Ratio = 50%
• Required Return = 14.1%

The current share price is $11.28 per share. The shares (relative to a single-stage residual income model) are most likely:

A) undervalued.

B) overvalued.

C) correctly valued.

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g = retention ratio × ROE = (0.50) × 0.22 = 0.11 or 11.00%