It’s been a long day but can anyone tell me why statement 3 is correct? I think of Residual income as RI=Net income - equity charge. Why would statement 3 be correct if it says it adjusts for all capital, debt and equity? The only thing I can think of is that Interest is subtracted from NI and then you subtract the equity charge…so you’ve adjusted for both.
Statement 1: Raman: As PRBI’s management is actively seeking opportunities to be acquired, the guideline public company method (GPCM) would be most appropriate as it establishes a value estimate based on pricing multiples derived from the acquisition of control of entire public or private companies that were acquired. Specifically, it uses a multiple that specifically relates to sales of entire companies.
Statement 2-Mendosa : We could also value PRBI using the free cash flow to equity (FCFE) model. But in order to support its rapid growth, the company is expected to significantly increase its net borrowing every year for the next three to five years, and during those years, it could have a significant dampening effect on the company’s FCFE and thus a lower value for its equity.
Statement 3-Raman : I agree. The residual income (RI) model, also called the “excess earnings method,” does not have the same weakness as the FCFE approach because residual income is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Furthermore, it makes no assumptions about future earnings and the justified P/B is directly related to expected future residual income.
In regard to the discussion on other approaches between Mendosa and Raman, which of the following statements that they make is most accurate? Statement:
Statement 3 by Raman is most accurate. The residual income model, also called the excess earnings method, does not have the same weakness as the FCFE approach, because it is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Further, it makes no assumptions about future earnings and dividend growth.