Lecture 7

Question 1

1. What is the formula for the value of equity when ancorded to common share holder equity
2. What are the steps when calculating the value of equity

Answer 1

1. Look at the notes
2. Forecast future residual income (RE)
   Calculate a continuing value
   Take present values and add to current book value of equity

Question 2

1. What is the adjustment to the RE model (formula)
2. What is the rational behind the modification of the RE model,

What are normally the type of assets or liabilities that we exclude. re

What are the assets that we focus on

When should we use the residual operating income model

Answer 2

Look at the notes

2. if (assumption) the market value of these assets and liabilities is equal to their intrinsic (fair) value (normally financial assets), in this case, the expected RE of these assets and liabilities is zero.

focus, instead on net assets (especially net operating assets NOA) that are not at market value are recorded as historical costs rather than current market value.

If you cant distinguish between net operating assets and normal asset then use the residual earnings model otherwise residual operating income model is much simpler and easier to use.

Question 3

1. Why can we focus on the residual operating income (ReOI) to value the firm, and forget about net financial expense which is included in the Re model.

What is the formula for ReOI

What else can the residual operating income method be referred to as.

Answer 3

1. Because NFO (net financial obligations) items are ususally reported at or close to their market value. The expected RE from these items is zero if their market value is equal to their fair value.
2. Look at the notes
3. The residual Operating income (ReOI) is sometimes called economic Profit or EVA (The Economic Value Added)

Question 4

1. If the residual earnings from NFO are expected to be zero, what does this imply.
2. What is the formula for valuing NOA, and the three cases of CV.
3. What can the value of net operating assets also referred to as.
4. What are the implication on the discount rate

Answer 4

1. If the residual earnings from NFO are expected to be zero, this means that the value of these NFO would be equal to the reported book value.
2. Look at the notes
3. value of the firm, enterprise value, or the value of operations
4. To value the whole firm we must use the weighted average cost of capital WACC as the discount rate

Question 5

What is the formula for common shareholder equity

Answer 5

Look at the lecture notes

Question 6

What are the advantages of valuing operations

Answer 6

Financing activities can be ignored for forecasting: focus on operations where the value is generated. In other words all you need is to forecast the core operating income and NOA

Required return does not have to be adjusted as leverage changes

Question 7

Why can assume that A & L reported at their market value have a residual earning of zero.

What is the implication of this

Answer 7

Residual earnings is earning in excess of the required rate of return. If something is fairly priced than it is earning at the required rate of return.

If its is fairly priced then it will be captured in the book value.

Question 8

Go over slide 9

Answer 8

Go over slide 9 and see if you can work out how the continuing value and residual operating income works

The trick: The value of equity is Enterprise value - NFO; but if the firm has NFA then you add the amount to enterprise value and arrive at the value of equity.