Table of Contents
CFA Level 2 – Equity, Session 12-Reading 45, Residual Income Valuation-LOS i
(Practice Questions, Sample Questions)
1. Which of the following statements least accurately explains the relationship between the residual income (RI) model, the dividend discount model (DDM), and free cash flow to equity (FCFE):
A) FCFE models use historical cash flows.
B) All the models discount future cash flows or income at the required rate of return.
C) RI models use an equity value from the balance sheet plus the present value of expected future residual income
<Explanation>: A) In theory, the same value or total present value should be derived using expected dividends, expected FCFE, or book value plus expected residual income if the underlying assumptions are the same. However, the recognition of value is different because FCFE and DDM models forecast future cash flows, while residual income models start with a balance sheet measure of equity and add the present value of expected future residual income. A residual income model can be used along with other models to assess the consistency of results.
2. Which description of the relationship among residual income, dividend discount (DDM) and free cash flow to equity (FCFE) models is least accurate?
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A) Residual income differs from DDM and FCFE in that residual income starts with book value.
B) The different models should result in different intrinsic values because of the theoretical differences in the models.
C) Residual income differs from DDM and FCFE in that it discounts income rather than cash.
<Explanation>: B) The three models should all produce the same intrinsic value as long as the underlying assumptions are the same. The differences in intrinsic values arise from difficulty in estimating the inputs, not from theoretical differences in the models. Since they should produce the same results, they can be used to assess consistency. Residual income differs from DDM and FCFE in the use of accounting assumptions, including book value and discounting income.
3. Which statement best describes the relationship between the residual income model and the free cash flow to equity model?
A) They do not rely on accounting assumptions.
B) Intrinsic value calculated by both should be the same if the assumptions are the same.
C) They both discount a future stream of cash flows
<Explanation>: B) Theoretically the intrinsic value calculated by both should be the same, but since they use different approaches the values are often different in practice. Residual income relies on book value and discounts income, not cash flow.
4. A use of the residual income (RI) valuation approach is:
A) deferring value more than in competing valuation approaches.
B) providing more reliable estimates of terminal value.
C) providing a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM)
<Explanation>: C) A RI model can be used along with other models to assess the consistency of results. FCFE and DDM models forecast future cash flows while RI models start with a balance sheet measure of equity and add the present value of expected future RI.
5. An argument for using the residual income (RI) valuation approach is that:
A) terminal value does not dominate total present value as is the case in dividend and free cash flow valuation models.
B) reliance on accounting data requires numerous and significant adjustments.
C) the models rely on accounting data that can be manipulated by management
<Explanation>: A) Terminal value does not dominate total present value as is the case in dividend and free cash flow valuation models. Both remaining responses are arguments against using the RI approach
6. An argument for using the residual income (RI) valuation approach is that:
A) the models rely on accounting data that can be manipulated by management.
B) the models focus on economic rather than just on accounting profitability.
C) the clean surplus relation fails to hold
<Explanation>: B) The models focus on economic rather than just on accounting profitability. Both remaining responses are arguments against using the RI approach
