Question #71
Reading: Reading 23 Residual Income Valuation
PDF File: Reading 23 Residual Income Valuation.pdf
Page: 34
Status: Unattempted
Correct Answer: B
Question
Which of the following statements least accurately explains the relationship between the residual income (RI) model, the dividend discount model (DDM), and free cash flow to equity (FCFE):
Answer Choices:
A. RI models use an equity value from the balance sheet plus the present value of expected future residual income
B. FCFE models use historical cash flows
C. All the models discount future cash flows or income at the required rate of return
Explanation
In theory, the same value or total present value should be derived using expected
dividends, expected FCFE, or book value plus expected residual income if the underlying
assumptions are the same. However, the recognition of value is different because FCFE
and DDM models forecast future cash flows, while residual income models start with a
balance sheet measure of equity and add the present value of expected future residual
income. A residual income model can be used along with other models to assess the
consistency of results.