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INV3701-chapter5

Chapter 5 discusses residual income valuation, which is calculated as net income minus an equity charge representing shareholders' opportunity costs. Positive residual income indicates value creation, while negative residual income suggests value destruction, impacting company valuations. The chapter also covers the residual income model, its relationship with other valuation models, and guidelines for its appropriate use.

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8 views6 pages

INV3701-chapter5

Chapter 5 discusses residual income valuation, which is calculated as net income minus an equity charge representing shareholders' opportunity costs. Positive residual income indicates value creation, while negative residual income suggests value destruction, impacting company valuations. The chapter also covers the residual income model, its relationship with other valuation models, and guidelines for its appropriate use.

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CHAPTER SUMMARY

• CHAPTER 5– RESIDUAL INCOME VALUATION

• Residual income is net income – equity charge ( shareholder’s


opportunity cost in generating net income).
• The income statement dos not deduct
– Dividends
– Other charges to equity capital
• There are two approaches to calculate residual income
– Refer to page 210-213
• Equity charge = Equity capital x cost of equity capital
• Debt charge = debt x after tax cost of debt
• Total capital charge = debt charge + equity charge
– Do example 5.1 page 211 – 212, work through page 210-213
• When income is >its cost to generate it, then residual income is
positive and there is creation of value.
• When income is <its cost to generate it, then residual income is
negative and there is destroying of value
• All else equal higher (lower) residual income should be associated
with higher (lower) valuations
• A company that generates positive economic profit (residual
income) should have a market value in excess of the accounting
book value
• MVA  Market value of company-Total capital
• EVA=NOPAT –(C% X TC) refer to page 214
• THE RESIDUAL INCOME MODEL
– Intrinsic value = current book value + present value of expected
residual income. Refer to page 215-218, do example 5-2 & 5-3
– Residual income model (1)

RI t
V0  B0  
t 1 (1  r )t

Et  rBt 1
 B0  
t 1 (1  r ) t

• The residual income model has a relationship with other valuation


models e.g. DDM
• Clean surplus relationship states among earnings, dividends an
Bt  Bt 1  Et  Dt
book value as;
– Clean surplus accounting – the condition that income
» Reflects all changes
» In book value of equity
» Other than ownership transactions
– Residual income model (2) refer to page 219-222, example 5-4

( ROEt  r )  Bt 1
V0  B0  
t 1 (1  r )t

– Fundamental determinates of residual income, refer to pg223-


224
– Single-stage residual income model (1)
• Example 5-6 page 224
– Single-stage residual income model (2)
• Example 5-7 page 225
• Multistage residual income valuations
– Estimating a terminal value is based on continuing residual
income at the end of that time horizon
– Continuing residual income is residual income after forecast
horizon.
– Following assumptions concerning continuing residual income
• Residual income continues indefinitely at a positive level.
• Residual income is zero from the terminal year forward.
• Residual income declines to zero as ROE reverts to the cost
of equity through time.
• Residual income reflects the reversion of ROE to some mean
level.
– Refer to page 225-230
• Strengths and weakness of the residual income model
– Refer to pages 232-233
• Broad guidelines for using a residual income model
– A residual model is most appropriate when,
– A residual model is least appropriate when
– Refer to pages 233-234
• Read through pages 234-249

• Read through SUMMARY on pages 250-251

• ADDITIONAL QUESTIONS
– Question 1,5-10, 13-14, 17

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