Deck 13: Valuation: Earnings-Based Approaches

Question 1

Residual income is the:

A) difference between the net sales that the analyst expects the firm to generate and the required earnings of the firm.
B) difference between the net income that the analyst expects the firm to generate and the required earnings of the firm.
C) difference between the common stock that the analyst expects the firm to issue and the required earnings of the firm.
D) difference between the expenses that the analyst expects the firm to generate and the required earnings of the firm.

Answer 1

B

Question 2

Jarrett Corp.
At the end of 2010 Jarrett Corp. developed the following forecasts of net income:

Management believes that after 2015 Jarrett will grow at a rate of 7% each year. Total common shareholders' equity was $112,768 on December 31, 2010. Jarrett has not established a dividend and does not plan to paying dividends during 2011 to 2015. Its cost of equity capital is 12%.
Compute the value of Jarrett Corp . on January 1, 2011, using the residual income valuation model. Use the half-year adjustment.

A) $112,768
B) $185,329
C) $195,540
D) $133,624

Answer 2

B

Question 3

At the beginning of 2012 investors had invested $25,000 of common equity in Grant Corp. and expect to earn a return of 11% per year. In addition, investors expect Grant Corp. to pay out 100% of income in dividends each year. Forecasts of Grant's net income are as follows:
2012 - $3,500
2013 - $3,200
2014 - $2,900
2015 and beyond - $2,750
Using this information, what is Grant's residual income valuation at the beginning of 2012?

A) $25,000
B) $26,350
C) $26,151
D) $26,041

Answer 3

C

Question 4

Assume that a firm's book value at the beginning of the year is $17,800 and that the firm reports net income of $6,200. If the firm's book value at the end of the year is $20,000 what was the amount of dividends paid during the year?

A) $4,000
B) $8,800
C) $2,200
D) Insufficient information to determine

Question 5

Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,500 at the end of 2010. During 2011 the firm earns net income of $1,900, pays dividends to shareholders of $200, and issues new stock to raise $500 of capital. The book value of shareholders' equity at the end of 2011 is:

A) $2,750
B) $250
C) $1,450
D) $3,700

Question 6

What would be Jarrett's residual income in 2013?

A) $24,552
B) $18,763
C) $5,789
D) $5,200

Question 7

What would be Jarrett's common shareholders' equity at the end of 2014?

A) $180,909
B) $208,161
C) $95,540
D) $112,768

Question 8

If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be:

A) exactly equal to the book value of common shareholders' equity.
B) greater than the book value of common shareholders' equity.
C) less than the book value of common shareholders' equity.
D) exactly equal to working capital.

Question 9

To measure a firm's economic performance and position in a given period, it makes sense to measure all of the following except :

A) The daily free cash flow published by the Wall Street Journal
B) Expenses incurred for resources consumed in that period
C) A portion of the long-lived resources consumed during that period
D) The cost of commitments made during that period to pay retirement benefits to employees in future periods

Question 10

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect:

A) the dividend paying ability of the firm.
B) the free cash flows available to shareholders.
C) the value of the firm to shareholders.
D) the value of the firm for debtholders and shareholders.

Question 11

Required earnings are the:

A) adjusted net income multiplied by the required rate of return on common equity capital.
B) net income the analyst expects the firm to generate multiplied by the required rate of return on common equity capital.
C) the market value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.
D) the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.

Question 12

Residual income is:

A) adjusted net income the firm reports.
B) the difference between the net income the analyst expects the firm to generate and the required earnings of the firm.
C) the difference between the net income the analyst expects the firm to generate and the reported earnings of the firm.
D) the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.

Question 13

At the beginning of 2012 investors had invested $125,000 of common equity in Jan Corp. and expect to earn a return of 15% per year. In addition, investors expect Jan Corp. to pay out 100% of income in dividends each year. Forecasts of Jan's net income are as follows:
2012 - $41,000
2013 - $35,400
2014 - $33,200
2015 and beyond - $25,000
Using this information, what is Jan's residual income valuation at the beginning of 2012?

A) $125,000
B) $184,600
C) $190,262
D) $190,262

Question 14

If investors have invested $20,000 of common equity in a company and it is determined that the required earnings of the company are $$1,250 each period, then investors must expect to earn what return?

A) the risk free rate
B) 9%
C) 6.25%
D) the market premium

Question 15

Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,600 at the end of 2010. During 2011 the firm earns net income of $1,300, pays dividends to shareholders of $600, and uses $300 to repurchase common shares. The book value of shareholders' equity at the end of 2011 is:

A) $2,000
B) $400
C) $3,800
D) $2,600

Question 16

Residual income will be greater than zero when:

A) the firm's reported net income exactly equals the required level of earnings necessary to cover the cost of equity capital.
B) the firm's expected future income is greater than the required level of earnings necessary to cover the cost of equity capital.
C) the firm's expected future income exactly equals the required level of earnings necessary to cover the cost of equity capital.
D) the firm's expected future income is less than the required level of earnings necessary to cover the cost of equity capital.

Question 17

The appropriate discount rate for the residual income model is:

A) weighted average cost of capital.
B) the risk-free interest rate.
C) the risk-free interest rate plus the market premium.
D) cost of common equity capital.

Question 18

Residual income in a long-run steady-state growth period is referred to as:

A) dynamic residual income
B) realistic residual income
C) continuing residual income
D) equilibrium residual income

Question 19

Assume that a firm's book value at the beginning of the year is $12,500 and that the firm reports net income of $3,200 and pays dividends of $1,100_. What will the firm's book value at the end of the year?

A) $2,100
B) $15,700
C) $14,600
D) $16,800

Question 20

Residual income valuation focuses on:

A) dividend-paying capacity in free-cash flows.
B) earnings as a periodic measure of shareholder wealth creation.
C) free cash flows as a periodic measure of shareholder wealth creation.
D) dividends as a periodic measure of shareholder wealth creation.

Question 21

If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be equal to the ______________________________ of common shareholders' equity.

Question 22

The residual income valuation approach assumes that accounting for net income and book value of shareholders' equity follows ________________________________________.

Question 23

Which of the following would likely be the most useful when valuing a dot.com company?

A) Net asset value
B) Dividend yield
C) Discounted cash flow
D) Price-earnings

Question 24

Economists sometimes argue that earnings are not a(n) _________________________ attribute on which to base valuation.

Question 25

The foundation for residual income valuation is the classical _____________________________________________.

Question 26

The required earnings of the firm equals the product of the required rate of return on common equity capital times the __________________________________________________ at the beginning of the period.

Question 27

Clean surplus accounting for most common stock transactions holds for shares accounted for at market value. An exception to this is:

A) issuance of common equity shares for employee stock options exercises.
B) repurchase of common shares.
C) issuance of common shares to new shareholders in public exchanges.
D) None of these.

Question 28

Over the life of the firm, the present value of ______________________________, ______________________________, and ____________________ will be the same.

Question 29

Residual income valuation focuses on ____________________ as a periodic measure of shareholder wealth creation.

Question 30

Accounting principles make accrual accounting earnings closer to the firm's underlying economic performance in a given period than are _________________________.

Question 31

Which of the following is probably the least likely reason for acquirers to pay too much in an acquisition?

A) Overbidding
B) Over optimistic appraisal of market potential
C) Over estimation of synergies
D) Overuse of conventional financial statements

Question 32

The residual income _____________________________ valuation model uses __________________ and the book value of common shareholders' equity as the basis for valuation.

Question 33

______________________________ is the amount by which expected future earnings exceed the required earnings.

Question 34

In some industries, competitive dynamics eventually drive long-run projections of the future returns earned by the firm to an equilibrium level equal to the long-run expected cost of equity capital in the firm. At that point, a firm can be expected to earn ____________ residual income in the future.

A) increasing
B) zero
C) decreasing
D) There is not enough information to answer this question

Question 35

The residual income valuation model is a rigorous and straightforward valuation approach, but the analyst should be aware of all of the following implementation issues that will hinder its ability to measure firm value correctly except :

A) common stock transactions
B) portions of net income attributable to equity claimants other than common shareholders
C) dirty surplus accounting items
D) positive book value of equity

Question 36

Early in a period in which sales were increasing at a modest rate and plan expansion and start-up costs were occurring at a rapid rate, a successful business would likely experience:

A) increased profits and no change in financing requirements.
B) decreased profits and increased financing requirements because of an increasing cash shortage.
C) decreased profits and decreased financing requirements because of an increasing cash surplus.
D) increased profits and increased financing requirements because of an increasing cash shortage.

Question 37

Dirty surplus items in U.S. GAAP typically arise from all of the following except :

A) changes in investment security fair values
B) foreign currency exchange rates
C) interest rates
D) realized gains

Question 38

The two most popular discounted earnings models appear to be:

A) free cash flow and dividend discount model.
B) sales/market capitalization and price-earnings.
C) discounted abnormal earnings and residual income.
D) price-cash flow and dividend discount.

Question 39

The value of a share of common equity should equal the present value of the _____________________________________________ that the shareholders will receive.

Question 40

In theory, all three valuation models, when correctly implemented with internally consistent assumptions, will produce the same estimates of value. However, in practice, which of the following errors can result in different value estimates?

A) Incomplete or inconsistent earnings and cash flow forecasts
B) Inconsistent estimates of weighted average costs of capital
C) Incorrect continuing value computations
D) All of these errors result in different value estimates.

Question 41

Over sufficiently long periods, _________________________ equals free cash flows to common equity.

Question 42

Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect the ______________________________ to the shareholders.

Question 43

Accounting for the residual income in a firm with 100% dividend payout can be expressed as follows:
RI_t = CI_t- ____________________ X BV_t-1

Question 44

Clean surplus accounting means that ____________________ include all direct capital transactions between the firm and the common equity shareholders.

Question 45

Accounting earnings numbers provide a basis for valuation because earnings are the primary measure of ______________________________ produced by the accrual accounting system.

Question 46

Clean surplus accounting means that net income includes all of the recognized elements of income for the firm for _____________________________________________.

Question 47

__________________ means that net income includes all of the recognized elements of income of the firm for common equity shareholders and dividends include all direct capital transactions between the firm and the common equity shareholders.

Question 48

____________________ are the fundamental, value-relevant attribute of expected future returns.

Question 49

When debating the issue of whether to use free cash flows or earnings in a valuation model, economists sometimes argue that ____________________ can be subject to purposeful management by a firm and thus make them less useful.