Equity Charge on RI Model

CFA Level II
#1

In my notes I have that the basic form of RI is calculated by taking Net income - Equity Charge (which is cost of equity x equity portion of value)

In some CFA EOC answers they are suggesting the equity capital must be multiplied by the ROE first before subtracting from the Net Income.

In the examples with my third party provider they just take the Cost of equity x the book value of equity.

Can someone elaborate please?

#2

If book value of equity at jan1 2016 is 100 roe for 2016 is 15% and r is 12% then net income=15 equity charge=12 RI=3. So in this case first find the net income and then subtract equity charge.

#3

Hey Rex. ROE is an alternative way to get RI, and an important one to make sure you have a handle on.

RI = EPS - (r x BV) This one you know.

EPS = ROE x BV

So …

RI = (ROE - r) x BV

Another way to get to the same result.

#4

Thanks both,

Just to extend this question…

When we calculate RI do we always take NI from teh current year and subtract equity charge from previous year?

An example asks to calculate the RI for 2003. The solution takes Net income from 2003 and subtracts BV Equity x cost of equity 2002.

RI is an area I need more work on. but I thought the T-1 only applied when looking at multi stage RI models with persistence factors.

Thanks

#5

Yes. You may be asked to calculate RI for 2 or 3 periods forward, then calculate a TV based on one of the typical methods ( e.g. sustainable growth, premium over book, persistence) then discount all that back + BV(0) to find intrinsic value.

Beginning BV + EPS(t) - Dividends(t) = Ending BV. That ending BV becomes the beginning BV for the next period, and is used to calculate the equity charge for that next period.

RI(t) = EPS(t) - (r x BV(t-1)

BV(t-1) is the BV for the beginning of the period, or stated differently, the ending BV of the previous period.