Question #38 - Reading 23 Residual Income Valuation

Reading: Reading 23 Residual Income Valuation

PDF File: Reading 23 Residual Income Valuation.pdf

Page: 21

Status: Unattempted

Shared Context

- Which of the following is least likely to characterize the difference between a residual income model and a FCFE model? A) Terminal value represents a higher proportion of intrinsic value in a residual income model than in a dividend discount model (DDM). B) A residual income model is applicable to a firm that does not have FCF. C) Inputs to a residual income model are more easily manipulated by management.

Question

Regarding their statements about ROE and residual income, who is correct? LaMarre Hofstedt

Answer Choices:

A. Correct Incorrect

B. Incorrect Correct

C. Correct Correct

Explanation

LaMarre is incorrect because the present value of the continuing residual income for a firm is equal to the current value divided by the return on equity when residual income continues indefinitely, which is not the case if ROE declines to the return on equity capital. Hofstedt is correct that ROE declining to the cost of equity capital implies a decline in residual income and thus a persistence factor between zero and one.

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