Equity question

Which of the following is the most appropriate response Kim can make to his supervisor’s final question? (i.e. why he prefers the residual income model to other approaches.) The analyst need not adjust book value of common equity for off-balance-sheet items.

The interest expense in the residual income model correctly captures the cost of debt capital.

The analyst need not adjust the book value of common equity for non-recurring items.

Incorrect.

Explanation: Although it is important to adjust income for non-recurring items, these adjustments do not need to be made to the book value because they are already reflected in the value of the assets.

Could someone please enlighten me as I don’t understand this.

What was the correct answer, and what’s the context of the question?

If I understand correctly, it means non-recurring items are not part of book value, because the non-recurring items are income related to assets exhibiting infrequent gains and losses. Like for example, the sale of an asset.

To me the answer is C, since the adjusting of non-recurring items is made with net income, and therefore the book value does not need a second adjustment. The answer they mention is correct as well, in the sense that book value = A - L, and A already reflects the offsetting part of the non-recurring items occuring in the income statement. Shitty question it is, no doubt.

Using the RI Model you will have to be carefull not to include non recurring items on your I/S, you will use the PV of those to get the value and its going to false your results.

And, (Good morning) MrSmart, non recurring items are par of the BV, the question is; why you wouldn’t change equity?

Because (of the clean surplus accounting assumption?) you have your change in equity flowing through the I/S. And on the Asset side of the B/S you are rightly already accounting for the non recurring item.

I think the question is strange because it’s mixing two principles of the RI Model, Clean surplus assumption and the nonrecurring, recurring I/S changes.

A recurring, non recurring item is not something you want to get rid of (like unconsistent capitalisation of expenses, there you take them out of BV) you just don’t want it to be wrongly impacting your PV for the Model, and you are using your I/S to forecast those future incomes.

Hope this helps and I am getting it right,

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And, yes, I like the answer about the Interest Expenses correctly reflecting the cost of debt. Then… Why is this less interesting than the non accounting change to the Equity…

If someone had a vision…?

Answer is C. Your adjustment on non-recurring items that appears in the P/L has already been applied on the Assets/Liabilities, hence BV of equity is actually adjusted for those items. Imagine you had a fire on your warehouse, which is a non-recurring item: an impairment will be booked in the Asset and the amount will appear in the P/L (hence, BV of equity will be lower by that amount). No second adjustment is needed.

Interest expense does not necessarily reflect true cost of debt. Markets constantly change, so if you’re keeping a loan carrying an annual interest of 7% since 2010, and the market would demand a 1.5% for new funds issued today, 7 is not a good indicator of your true cost of debt, no?

Your interest expense is 7 while you’re true cost of debt should be 1.5 (assuming both issuances are identical, obiously).

You can also think of inflation… It reduces the real value of your liabilities, so the interest expense of 5 that could look expensive 5 years ago, it may look ridiculous today under a high inflation scenario.

I am completely sure about the inflation impact on the interest expense, but I would like confirmation on the previous one, though (market changes).

Cheers

I guess the RI model does not capture the cost of debt correctly from interest expense is because it is a valuation based on book values. So the interest expense on the income statement / BV of debt is not the effective cost of debt, as you would get from interest/ MV of debt.

Non recurring items should not be adjusted on the balance sheet because the balance sheet is not non-recurring in nature, Meaning that one time gains and losses might be adjusted for in income for a pro forma valuation, and this would be sufficent without needing to adjust the balance sheet as well.

For example, if you assume that there will be no gain/loss on sale of assets, and no extraordinary events like inventory obsolescence, then you leave the balance sheet untouched as well. Because in a pro-forma scenario, there is nothing outstanding that calls for a change in normal operation. Non-recurring items in the past are already reflected on the balance sheet in terms of more or less assets, or more or less liabilities (cash from sale of property in BV + cash from gain on BV).

Hope this makes sense.

Edit: The poster above provides a better explanation.

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