Calculating Equity Charge for Residual Income Valuation

Hey, a bit confused. In the Exercise that follows Residual Income Valuation from the CFA Notes. Question 24 and 25, Ending Book Value was used to calculate the Equity Charge. However, in Question 33, the Beginning Book Value was used. Am I missing something? Thanks.

Hi,

Ending book value is actually the same thing as beginning book value. They can be used interchangeably unless mentioned otherwise in the question.

Ending BV is not the same as Beg BV. Beg BV + Retained Earnings = Ending BV.

Not quite.

Assuming no shares issued or repurchased and no additional paid-in capital:

Ending\ BV = Beginning\ BV + Net\ Income + \Delta OCI - Dividends\ Declared
= Beginning\ BV + \Delta Retained\ Earnings

Note that for the clean surplus assumption, ∆OCI is assumed to be zero.

Please guys it’s better to study the Residual Income Valuation Model LOS before answering my question or at least read the questions I refer to in this question. The formula to get the Ending Book V is (Beg Book Value + (EPS - Dividends) while the Residual Income is EPS - (Required Rate of Return * Book Value). The Chapter is about deriving residual income when EPS and Dividends are given for a number of consecutive years. There is no discussion on paid in capital or Delta OCI or other ways you calculate Retained Earnings. The LOS is quite specific on what the candidate should have knowledge on. I just need to know why the required rate of return was multiplied by the Ending Book Value in question 24 and 25 to derive residual income but the Beginning Book Value was used in Question 33. Thank you and sorry I sound frustrated.

It could actually be an error. I haven’t checked the CFA errata. But I also maybe missing something.

Note that that’s Dividends Declared, not Dividends Paid.

The problem is that you wrote:

This is incorrect.You don’t add Retained Earnings; you add the change in Retained Earnings: ∆RE.

In any case, the charge should be computed on beginning BV, not on ending (or average) BV.