Topic 5

Question 1

what does residual income mean

Answer 1

Earnings in excess of equity charge

Question 2

what is an assumption of residual income model

Answer 2

clean surplus relations hold

Question 3

What is the value of equity in the general RI model

Answer 3

Book value of common stock + present value of future residual income

Question 4

When is the RI model most appropriate

Answer 4

1. Small or zero dividends payments
2. Negative or no cash flows
3. When terminal values are highly uncertain

Question 5

When is the RI model least appropriate

Answer 5

1. When clean surplus relationship does not hold

2. When the determinants of residual income are not predictable

Question 6

Whats the main difference between DDM, FCFEM, RIM

Answer 6

The ways they recognise value

RIM - the book value takes up a large proportion of current value
FCFEM/DDM - The terminal value Pt takes up a large proportion of current value

Question 7

Using single RI model what two ways can you calculate value

Answer 7

1. Calculate the value of the stock
   = Book value + [(ROE-r)/(r-g)]* book value
2. Calculate justfied P/B and actual PB
   justified = 1 + [(ROE-r)/(r-g)]
   actual = current stock price/ book value eps

Question 8

In the multistage RI model what does w stand for and mean

Answer 8

persistence factor - the extent to which RI will continue or fade after the forecast horizon

ω = 1: RI does not decline and will continue indefinitely
ω = 0: RI stops after forecast horizon
0 < ω < 1: RI will decline

Question 9

Name 4 strengths of RIM

Answer 9

1. Put less weight on terminal value - useful when CF are unpredictable
2. Use accounting data based on economic value
3. Is useful for non-dividend paying firms
4. Is useful for firms without FCF

Question 10

Name weaknesses of RIM

Answer 10

1. May need accounting adjustments
2. accounting date more likely to be manipulated
3. Rely on clean surplus accounting assumption