Question #68 - Reading 23 Residual Income Valuation

Reading: Reading 23 Residual Income Valuation

PDF File: Reading 23 Residual Income Valuation.pdf

Page: 33

Status: Unattempted

Correct Answer: B

Shared Context

- When a company's ROE is the same as the return required by the market, the stock's justified market value is closest to the: A) book value plus residual income. B) actual market value plus residual income. C) book value.

Question

Which of the following assumptions is not commonly used to simplify the calculation of residual income? Continuing residual income is expected to:

Answer Choices:

A. disappear immediately

B. decline to the market average

C. decline gradually as ROE declines

Explanation

A common assumption involves residual income declining to an average level consistent with a mature industry. This assumption makes sense, considering that we generally calculate residual income for an individual company, and the company's industry average is quite possibly the best benchmark for its future income-generation potential. The market average is not generally used as a proxy. Both remaining assumptions are commonly used.

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