Looking at Schweser reading 36 pg 208 for this. The question (only selected parts) says: Calculate the intrinsic value of the company using a residual income model, assuming that after 5 years residual income remains constant. The answer says the following:

The $0.44 perpetuity beginning in Year 5 is worth $4.40 ($0.44/0.1) in Year 4. The intrinsic value is V0 = 5 + [$0.25/1.1 + $0.29/1.1^2 + $0.33/1.10^3 + $0.38 + $4.40 / 1.10^4] = $8.98

My question is: why are they using terminal value year 4? Question says after year 5 residual is constant, so why are we not using terminal value year 5 = Residual income yr 6 / 1+r -1

Can someone please help on this. For the next part of the question, they say "after year 5, residual income will decay over time to zero with a persistence factor of 0.4. Calculate residual income.

Answer says: residual income begins to decline after year 5, so the present value in year 4 includes the present value of year 5 residual income. Terminal value in year 4 = 0.44 / 1+0.1-0.4.

Isn’t this saying that year 6 (after year 5) is the first year of decay, so you must use terminal value 5 = RI6 / 1+0.1-0.4. Would really appreciate help on this.

Thanks Raw. This is from Schweser Reading 36, haven’t got a cfai example.

More thinking about it conceptually, if residual income declines after year 5, don’t we use terminal value year 5 = Residual income 6 / 1+r-g. As in the first year of decline is year 6, hence we use terminal value year 5?

because they said on year 5 it’s constant already. if you think DDM models they always says “after” 4 years volatile growth will be constant growth of 3%. when we see that we always find terminal value at year 4 the last year of volatile growth.

if you think about this question the last year of volatile growth before it’s constant is year 4. that’s why terminal value is year 4

*edit: if im looking at the same question. it says assume instead of after 5 year, it is constant. it’s saying before it was after 5 years NOW it’s constant on 5th year.