Residual Income Q42 Kaplan Practice Exam Vol2, PM

CFA Level II
#1

For this question only, assume that the chairman has drawn up budgetary forecasts for 20X7 that suggest that residual income will be $5m for the year ahead. You believe that this will increase by 5% per year for the foreseeable future.

Also given: Re=.15

Using the residual income method, the value of Prizm’s equity as of 31st December 20X6 is closest to:

$144.5 million.

$147.0 million.

$177.2 million.

Value of equity = book value of equity + PV of residual income Value as of 31 December 20X6:

= 94.5 + [5 ÷ (0.15 - 0.05)] = $144.5m

My Q : Sine we’re to calculate the PV of RI in the equation, shouldn’t we be using (1+Re) as discount?

I wasn’t able to find the formula Kaplan is referring to in the CFAI text. Anybody else think this may be incorrect?

#2

You are told to calculate Equity Value of the company.

A way to calculate it is using Residual Income Method (other methods are FCFF - Debt, FCFEE, DDM, etc).

Equity value = Book Value of equity + Present Value of the future stream of Residual Incomes

We must assume as the question states, that annual RI of US$ 5MM is infinite (for the foreseeable future, but note there are special formulas to bring RI to 0 at a certain time in the future. However in this case not). The RI is infinite and will grow 5% annually. This is enough info to realize we must use Gordon formula for an infinite flow:

PV of RI = RI / (Re - g) = 5 / (0.15 - 0.05) = 50

Equity value = 94.5 + 50 = 144.5

Hope this helps!

#3

It does. I’m still a bit uncomfortable adding the BV, but I guess I will have to commit this one to memory. Thank you!

#4

The logic, more or less, goes this way.

You may have realized by now that stock prices are practically always above book values per share. Book value per share is just the Total Equity of Balance Sheet divided by the number of shares outstanding.

What’s the difference between the observable stock prices and the book values per share? Yup, the present value of future residual incomes. Nothing more, nothing less.

This is why you add PV of RI to the BV in order to get the equity market value. Simple as that.

Look again at the formula to get residual income flow. It calculates the income above the required income according to the book value of equity (book value of equity is the investment made by the investors).

Hope this helps a little more.

#5

If ROE >re then your residual income is positive and so you add it to BV. Otherwise if roe is equal to re you don’t generate any residual income and your equity is just worth the BV