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
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