CFA Level 2 - Equity Session 12-Reading 45 Residual Income Valuation-LOS d (Practice Questions, Sample Questions) 1. Assuming that the growth rate is less than the required rate of return (r), an increase in return on equity (ROE) will causevalue in a residual income (RI) model to: A) there is insu cient information to derive the e ects of increasingROE on RI. B) increase if ROE is greater than the required rate of return. C) decrease if ROE is greater than the required rate of return <Explanation> An increase (decrease) in ROE increases (decreases) value if the ROE exceeds the required rate ofreturn. This is revealed by the RI valuation expression:V0 = B0 + [(ROE – r) / (r – g)]B0 2. Professor Cli Webley made the following statements in his asset-valuation class: Statement 1: “Over time, a company’s residual income growthtends to approach the industry average.”Statement 2: “If actual return on equity equals required returnon equity, the residual income model sets the company’sproper market value equal to its book value.”Statement 3: “The single-stage residual income model shouldgive you the same valuation as the Gordon Growth model.” Which of Webley’s statements is least accurate? A) Statement 2.
B) Statement 1. C) Statement 3 <Explanation> Over time, a company’s residual income growth tends to approach zero. It is unlikely that an industry’saverage growth rate is zero, so Statement 1 is questionable.The other two statements are accurate 3. The single-stage residual income model values a company at: A) book value times a factor determined by the discount rate.B) book value plus the terminal value discounted at the weightedaverage cost of capital. C) book value plus the present value of the ﬁrm’s expectedeconomic proﬁts <Explanation> The single-stage residual income model values a company at book value plus the present value of the ﬁrm’seconomic proﬁts, or the additional value generated by theﬁrm’s ability to produce returns higher than the cost of equity 4. Tobin’s Q is best expressed as: A) (Market Value of Debt + Book Value of Equity) / Replacement cost oftotal assets. B) (Market Value of Debt + Market Value of Equity) /Replacement cost of total assets. C) (Market Value of Debt + Book Value of Equity) / Book value of totalassets <Explanation> Tobin’s Q is (Market Value of Debt + Market Value of Equity) / Replacement cost of total assets