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Free CFA® CFA-Level-II Exam Braindumps (page: 35)

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De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Are De Jong's justifications for using the residual income model correct?

  1. Yes.
  2. No, because the residual income model should be not be used when cash flows are difficult to forecast.
  3. No, because the residual income model depends on positive free cash flows in the near future.

Answer(s): A

Explanation:

All of the justifications noted by De Jong are appropriate reasons to use the residual income model. (Study Session 12, LOS 43.m)



De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

Which of De Jong's assumptions about continuing residual income is least appropriate!

  1. Assumption 1.
  2. Assumption 2.
  3. Assumption 3.

Answer(s): C

Explanation:

It is not frequently assumed that the growth rate in residual income declines over time and eventually reaches zero. Instead, it is assumed that the level of residual income declines over time and eventually reaches zero. {Study Session 12, LOS 43.h,i)



De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

O'Connor's residual income and economic value added (EVA) for 2008 are closest to:
Residual income EVA

  1. $6.1 million $11.0 million
  2. $4.2 million $11.0 million
  3. $4.2 million $2.6 million

Answer(s): B

Explanation:

Residual income = nci income - equity charge
Equity charge = equity capital x cost of equity capital
Equity charge = $73,000,000 x 0.08 = $5,840,000
Residual income - $10,035,000 - $5,840,000 = $4,195,000
EVA = NOPAT - (C% x TC)
EVA = $28,517,640 - (0.054 x $324,000,000) = $11,021,640
(Study Session 12, LOS 43.a)



De Jong continues her analysis of O'Connor. She is concerned that along with a dividend discount model approach she would also like to get a measure of the contribution that the key managers, Melanie and Arthur O'Connor, have made to the company's apparent ongoing success.

She considers using NOPAT and EVA to assess management performance. She believes that increasing invested capital to take advantage of projects with positive net present values increases both NOPAT and EVA.

However, De Jong decides to use residual income analysis instead. She provides the following justification for using the residual income model:

• The calculation of residual income depends primarily on readily available accounting data.
• The residual income model can be used even when cash flow is difficult to forecast.
• The residual income model does not depend on dividend payments or on positive free cash flows in the near future.
• The residual income model depends on the validity of the clean surplus relation.

She also considers the following assumptions about continuing residual income:
Assumption 1: Residual income is positive and continues at the same level year after year. Assumption 2: As return on equity approaches the cost of equity, residual income tends to zero.
Assumption 3: Residual income growth declines overtime and eventually reaches zero.

De Jong gathers recent financial information data on O'Connor, as shown in Exhibit I.



De Jong has also determined that at the beginning of 2008, O'Connor had total capital of
$324,000,000, of which $251,000,000 was debt and $73,000,000 was equity. The company's cost of debt before taxes is 7%, and the cost of equity capital is 8%. The company has a tax rate of approximately 34%. Weighted average cost of capital is 5.4%. Net operating profit after tax (before any adjustments) is $28,517,640.

De Jong is interested in obtaining the market's assessment of the implied growth rate in residual income and notes that the book value per share for O'Connor at the beginning of 2009 was $4.29, and the current market price is $70. She forecasts the return on equity (ROE) for 2009 to be 11.84%.

De Jong discusses her analyses with a colleague, who makes the following general statements:

Statement 1: It is usually the case that value is recognized later in the residual income model than in the dividend discount model.
Statement 2: When the present value of expected future residual income is negative, the justified P/B based on fundamentals is less than one.

The implied residual income growth rate for 2009, based on the residual income model, is closest to:

  1. 7.75%.
  2. 8.16%.
  3. 8.82%.

Answer(s): A

Explanation:

We need to solve (or g in the relationship:

Solving for g, wc get g = 7.75%. (Study Session 12, LOS 43.g)



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