SD12-The Residual Income Model

SD12-The Residual Income Model - CHAPTER 12 THE RESIDUAL...

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CHAPTER 12 THE RESIDUAL INCOME MODEL LEARNING OBJECTIVES 1. How the residual income model works. 2. How to determine residual income. 3. Why the residual income model is a cash flow model. 4. That the residual income model provides the same results as the other cash flow models, given the same assumptions. TRUE/FALSE QUESTIONS 1. Since the residual income model describes value as a function of book value and residual income, it is not considered a cash flow model. (easy, L.O. 1, Section 1, false) 2. Any free cash flow forecast can be transformed into a residual income forecast, and any residual income forecast can be transformed into a free cash flow forecast. (moderate, L.O. 1, Section 1, true) 3. The residual income model is valid under all accounting methods whether the methods adhere to the concept of clean surplus or not. (difficult, L.O. 1, Section 1, false) 4. The residual income model is like the free cash flow model because it requires an infinite period forecast. (moderate, L.O. 2, Section 2, true) 5. Under the residual income model, the terminal value approach should give the same value regardless of the accounting method because the accounting method used does not affect value. (moderate, L.O. 2, Section 2, true) 6. The perpetuity formula used in the residual income model is less complicated than it is in the free cash flow and dividend discount models. (difficult, L.O. 2, Section 2, false) 7. The assumption that during the perpetuity period the firm no longer has any competitive advantage is based on the underlying economics of the industry. (moderate, L.O. 2, Section 2, true) 8. When the residual income and free cash flow model produce different results, the reason must be that different assumptions are used. (moderate, L.O. 2, Section 2, true) 9. The fundamental problem with the zero perpetuity assumption is that it is based on an underlying economic assumption about the firm or its industry. (moderate, L.O. 2, Section 2, false) 10. If it is assumed that residual income is a perpetuity growing at some constant rate, the value of minority interest will change slightly. (difficult, L.O. 2, Section 2, true) 11. When the residual income model uses the terminal value assumption of zero net present value investments, the value it produces is consistent with an eventual loss of competitive advantage and it 78
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does not depend on the firm’s accounting methods. (moderate, L.O. 2, Section 2, true) 12. A change in accounting methods will affect the value determined by the residual income model. (difficult, L.O. 4, Section 3, false) 13. Residual income valuations are more precise because of the uncertainty surrounding cash flows very far out in the future.
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This note was uploaded on 11/22/2010 for the course CAC BSA taught by Professor Kairus during the Spring '10 term at Korea University.

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SD12-The Residual Income Model - CHAPTER 12 THE RESIDUAL...

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