Question #1
Reading: Reading 23 Residual Income Valuation
PDF File: Reading 23 Residual Income Valuation.pdf
Page: 1
Status: Correct
Correct Answer: A
Question
Assuming that the growth rate is less than the required rate of return (r), an increase in return on equity (ROE) will cause value in a residual income (RI) model to:
Answer Choices:
A. increase if ROE is greater than the required rate of return
B. there is insufficient information to derive the effects of increasing ROE on RI
C. decrease if ROE is greater than the required rate of return
Explanation
An increase (decrease) in ROE increases (decreases) value if the ROE exceeds the required
rate of return. This is revealed by the RI valuation expression:
V0 = B0 + [(ROE – r) / (r – g)]B0