CFA Level 2 - Equity Session 12 - Reading 45 Residual Income Valuation-LOS h

CFA Level 2 – Equity, Session 12-Reading 45

Residual Income Valuation-LOS h

(Practice Questions, Sample Questions)

1. Continuing residual income is defined as the:

A) permanent as opposed to the transitory part of residual income.

B) residual income that is expected beyond the initial forecast time horizon.

C) residual income that forces the net present value to zero

Explanation — (B): Continuing residual income is defined as the residual income that is expected beyond the initial forecast time horizon. It comes into play when RI is forecast for a defined time horizon and a terminal value based on continuing RI is estimated at the end of that time frame

2. A common assumption regarding continuing residual income (RI) is that RI:

A) falls to the average industry level.

B) manifests a generally increasing trend indefinitely.

C) declines to zero as return on equity (ROE) drops to the cost of equity over time

Explanation — (C): It is common to assume that RI declines to zero as ROE drops to the cost of equity over time.

Other assumptions analysts may make include RI continues indefinitely at a positive level or RI reflects a decline in ROE to a long-run average level.

3. The present value of Raver Industries’ projected residual income (RI) for the next five years is ￡60 per share. Beyond that time horizon, a key analyst projects that the firm will sustain a RI of ￡11 per share, which is the RI for year 5. Given a cost of equity of 12%, what is the terminal value of the stock as of year 5?

A) ￡500.00.

B) ￡91.67.

C) ￡560.00

Explanation — (B): The stock’s terminal value as of year 5 is:

TV = 11.00 / 0.12 = 91.67

4. The present value of GB Industries’ projected residual income (RI) for the next five years is 70 per share. Beyond that time horizon, a key analyst projects that the firm will sustain a RI of 15 per share, which is the RI for year 5. Given a cost of equity of 12%, what is the terminal value of the stock as of year 5?

A) ￡500.00.

B) ￡560.00.

C) ￡125.00

Explanation — (C): The stock’s terminal value as of year 5 is:

TV = 15.00/0.12 = 125.00

5. The present value of Forman Electronics’ projected residual income (RI) for the next five years is ￡80 per share. Beyond that time horizon a key analyst projects that the firm will sustain a RI of ￡17 per share, which is the RI for year 5. Given a cost of equity of 13%, what is the terminal value of the stock as of year 5?

A) ￡130.77.

B) ￡500.00.

C) ￡19.96

Explanation — (A): The stock’s terminal value as of year 5 is:

TV = 17.00 / 0.13 = 130.77