Question #66

Theoretically the intrinsic value calculated by both should be the same, but since they use different approaches the values are often different in practice. Residual income relies on book value and discounts income, not cash flow. (Module 23.5, LOS 23.i) Sue Clifton, CFA, is a senior portfolio manager at Lewiston Investments, a small research firm. Clifton has been assigned to help new hire Ralph Rawls get acclimated to his new job as a stock analyst. She discovers early on that Rawls is not too familiar with residual income valuation, a tool for determining economic profitability. Clifton explains the basics of the residual-income model and the clean surplus relationship that underpins the system. Clifton explains to Rawls that analysts use assumptions to make the residual-income models easier to interpret. She goes on to identify four commonly used assumptions: Residual income can be expected to: disappear immediately decline gradually as return on equity (ROE) declines stay at the same level indefinitely decline to the market average After her initial review of residual income, Clifton gives Rawls a test. The answers depend on the use of the following information about CR Industries in Year X (in $ millions): Invested capital $225 Market capitalization $231 Debt $130 Sales $90 Cost of goods sold (COGS) $26 Selling, general & administrative (SG&A) expense $10 Depreciation and amortization expense $25 Interest expense $6.5 Dividend expense $6 Tax rate 40.0% Pretax cost of equity 11.4% Pretax cost of debt 5.00%