i read this on page 502 in book 4.
The potential weaknesses of residual income models include the following:
The residual income model’s use of accounting income assumes that the cost of debt capital is reflected appropriately by interest expense.
why is this a weakness? what is the above statement actually saying? confused.
Accounting income can be easily manipulated by management and the residual income model relies on it thus making it a weakness.
violation of the clean surplus relation
the statement talks about about interest expense specifically here. there are a lot of components that can make net income dubious- why did they mention interest expense specifically.
any idea please
Because we are operating in a changing market, so by assuming that the interest expense reflected in the income statement is a good proxy for the actual cost of debt when the market’s interest has changed higher or lower, you are underestimating/overestimating your cost of debt.
And remember, you are performing this valuation to be a obtain the fair value that an investor may use, so it needs to reflect market conditions, not the internal assumptions of cost of debt for example