Equity lvl2 - Reading 37 (Residual Income)

Question 1

Define residual income

Answer 1

aka economic profit, NI of firm - equity charge that measure stockholders’ opportunity cost of capital

Question 2

why use the residual income model?

Answer 2

it recognizing the cost of equity capital in measurement of income

Question 3

Formula for equity charge

Answer 3

equity capital x cost of equity

Question 4

Formula for residual income

Answer 4

NI - equity charge

Question 5

what does EVA stand for?

Answer 5

economic value added

Question 6

Define EVA

Answer 6

EVA “measures the value added for shareholder by management during a given year”

Question 7

Formula for EVA

Answer 7

=NOPAT - (WACC x total capital)

Question 8

Formula for NOPAT

Answer 8

EBIT x(1-t)

Question 9

define MVA

Answer 9

market value added =”difference btwn Mkt Val of firm’s long term debt and equity & BV of invested capital

Question 10

formula for MVA

Answer 10

=market value - total capital

Question 11

Formula to calculate RI (residual income) using EPS

Answer 11

RI = EPS expected - (r x BVt-1)

Expected EPS - required return x BV per share in year t-1

Question 12

Formula to calculate RI (residual income) using ROE

Answer 12

RI = (ROE - r) x BVt-1

(ROE - required return)x Book value per share in year t-1

Question 13

Formula for forecast BVPS for residual income calculation

Answer 13

Bt-1 +EPSt - Dt
(BVPS beginning + EPS forecast - divided forecast)
Div forecast = EPS x payout ratio

Question 14

Formula for dividend forecast

Answer 14

EPS x payout ratio

Question 15

Formula for equity charge for residual income

Answer 15

r x Bt-1

required return x BVPS beginning

Question 16

Define single-stage residual income

Answer 16

a model using simlifying assumptions of constant dividend and earnings growth rate to show the fundamental drivers of residual income. Looks like gordon growth model

Question 17

Describe the fundamental driver of residual income referring to ROE>r

Answer 17

if ROE = r, then MV = BV but if ROE is greater than r then the firm has positive residual income and is greater than BV

Question 18

Formula for single stage residual income

Answer 18

V0=B0+[(ROE-r) x B0 / (r-g)]

Question 19

Formula for forecasted earnings

Answer 19

E1 = BV x ROE