Question #53

Bias is likely when standards allow charges directly to stockholders' equity while bypassing the income statement. Both remaining responses are consistent with the use of data that will not introduce a bias. (Module 23.5, LOS 23.k) Ilias Chair has read a recent article on the internet which championed the benefits of using a residual income model to calculate company valuations. He is having trouble understanding the model, and has presented you with the following assumptions for a hypothetical company that the article used, and would like to know the valuation it results in. RI Inc. Return on equity 4.6% Retention rate 0.6 Current book value per share $8.50 Required rate of return for equity holders 4% Chair currently uses dividend valuation methodology to compute intrinsic value. He is interested to know if residual income models could be adapted and used instead of the dividend discount model (DDM). Chair has two main concerns about using it instead of the DDM: Concern 1: The residual income model seems to be to some extent dependent on book value per share, which may be calculated differently according to the accounting policy choices a firm makes. Concern 2: It's a shame that all residual income models assume constant growth in economic profit. It seems unreasonable to assume that economic profits can be sustained let alone grow at a constant rate. The models don't seem to factor in the impact of competition on future residual income. Ilias is also trying to assess a fundamental value of yet another company in the sector, Topper Inc., using the residual income model. He believes that the current value of Topper is primarily based on the current book value plus the present value of residual income for the next three years. Ilias estimates the required return to equity holders to be 4% pa. The current book value per share is $8.50. He has estimated the EPS forecasts for the next three years to be $1.50, $1.40, and $1.35 respectively. Her estimates for the dividend per share for the next three years are $0.70, $0.75, and $0.80 respectively. Chair does have concerns about the use of a residual income model for Topper. Ilias has extracted the following from the Accounting Policies Note in Topper's most recent annual report: Foreign Subsidiaries: Topper Inc. has two foreign subsidiaries which are both based in Europe and for the purposes of the group accounts, Topper has assumed that the Euro is the functional currency for both, and hence, used the current rate method for translation into the group reporting currency (U.S. dollars). Financial Instruments: Topper Inc. owns $3 million of par value bonds issued by Pastini Inc., which are due to mature in 2x18. The group intends to hold the bonds until 2x18 and hence they have been classed as amortized cost on the Group Balance Sheet.