Reading 45: Residual Income Valuation- LOS a(part1)～ Q1-3

interpret, equity, assets, software, relevant

LOS a, (Part 1): Calculate and interpret residual income.

Q1. Cognitive Products (CP) designs decision-making software. The book value of its assets is $3.2 billion, which is financed with $2.0 billion in equity and $1.2 billion in debt. Its before-tax cost of debt is 6.5%, while its relevant tax rate is 34%. CP has a cost of equity of 12.46%. Its abbreviated income statement is:

Earnings before interest and taxes (EBIT)	$213,000,000
Interest expense	(30,000,000)
Pretax income	183,000,000
Income tax expense	(62,220,000)
Net income	$120,780,000

The residual income (RI) for CP is closest to:

A) –$128,471,000.

B) –$128,369,000.

C) –$128,420,000.

Q2. Sue Clifton, CFA, is a senior portfolio manager at Lewiston Investments, a small research firm. Clifton has been assigned to help new hire Ralph Rawls get acclimated to his new job as a stock analyst. She discovers early on that Rawls is not too familiar with residual income valuation, a tool for determining economic profitability.

Clifton explains the basics of the residual-income model and the clean surplus relationship that underpins the system. Clifton then offers Rawls some reasons why residual income is useful:

Reason 1:	“Residual-income valuation works even when cash flows are volatile or negative.”
Reason 2:	“Terminal value, the most uncertain aspect of dividend discount models, is less important in residual-income valuation.”
Reason 3:	“The models depend on data that is easy to obtain and requires minimal modification.”
Reason 4:	“All residual-income models are dependent on assumptions about earnings growth.”

Clifton explains to Rawls that analysts use assumptions to make the residual-income models easier to interpret. She goes on to identify four commonly used assumptions: Residual income can be expected to:

disappear immediately
decline gradually as return on equity (ROE) declines
stay at the same level indefinitely
decline to the market average

After her initial review of residual income, Clifton gives Rawls a test. The answers depend on the use of the following information about CR Industries in Year X (in $ millions):

Invested capital	$225
Market capitalization	$231
Tax rate	40.0%
Interest expense	$12
Depreciation and amortization expense	$25
Selling, general & administrative (SG&A) expense	$10
Dividend expense	$6
Debt	$130
Cost of goods sold (COGS)	$26
Sales	$90
Pretax cost of equity	11.4%
Pretax cost of debt	5.0%

When a company’s ROE is the same as the return required by the market, the stock’s justified market value is closest to the:

A) actual market value plus residual income.

B) book value.

C) book value plus residual income.

Q3. Which of the following assumptions is not commonly used to simplify the calculation of residual income? Continuing residual income is expected to:

A) decline to the market average.

B) decline gradually as ROE declines.

C) disappear immediately.