428_lecture11_RIM_A_S09

428_lecture11_RIM_A_S09 - Valuation Class 11 Residual...

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Valuation Class 11 Residual Income Model Some notes based on Easton, et al (2001)
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Does Earning make more sense or does cash flow make more sense? NI CFO CFI FCF “V” = PV(all future CF) 1) Change from straight line depreciation to accelerated depreciation 2) Collect large receivables 3) Buy big machine with cash 4) FDA approves a drug that your company has developed
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Investment and disinvestment by owners   Net income and other earnings   Net change in owners’ equity Statement of Shareholders’ Equity Statement of Shareholders’ Equity   Revenues Net income Income Statement Income Statement Cash from operations Cash from investing Cash from financing Net change in cash Cash Flow Statement Cash - Liabilities Total Assets Owners’ equity Beginning Balance Sheet Beginning Balance Sheet + Other Assets - Liabilities Cash Total Assets Owners’ equity Ending Balance Sheet Ending Balance Sheet Beginning stocks Flows Ending stocks    Other   Assets  + Expenses What Links Are Missing?                                                       
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Outline Different Valuation models Residual Income Deriving RIM
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The Stocks and Flows Equation Assets Liabilities Equity Earnings 1 Earnings 2 Equity B 0 Year 2 B 1 + Earnings 2 - d 2 = B 2 B 2 - B 1 = Earnings 2 - d 2 Equity B 2 d 2 The Updating Equity Growth Year 1 B 0 + Earnings 1 - d 1 = B 1 B 1 - B 0 = Earnings 1 - d 1 Equity d 1 B 1
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Residual Income as a single-period performance metric RI t+1 = Earnings t+1 - (r*Capital t ) “RI” - Edwards & Bell (63); Ohlson (92) “EVA tm” - Stern Stewart (91) “Economic Profit tm” - McKinsey & Co. (95) “Abnormal earnings” - Palepu et. al. (97) Cost-of- capital Asset base What we earned x ( ) -
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Residual Income: Examples 1. If everyone in this class will at least get 70 points. Are you good to get 70 points? 2. If bank deposit interest is 5% you invest $100 dollars for me and return me $105 dollars in one year. You don’t add value for me. 3. If shareholders’ required rate of return is (-1) is 10%, and company management earn ROE of 10%,there is no value added, and the management does not deserve bonus. 4. So NI is a measure of profitability, but it is not a measure of management’s performance. RI is.
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Why is EVA/Residual Income Model so useful? What did the author claim? What is his argument and evidence?
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