Seeing is believing!
Before you order, simply sign up for a free user account and in seconds you'll be experiencing the best in CFA exam preparation.
Basic Question 2 of 2
An analyst is conducting a valuation for DEF Corp. This company has a dividend payout ratio of 25% and is expected to exhibit an ROE of 22% over the next three years. Thereafter, the "residual income" will remain constant. If the book value of DEF is currently $27.50, and the required rate of return on equity is 9%, which of the following would best estimate the terminal value of the residual income at the end of year three?
B. $37.65
C. $53.89
A. $27.58
B. $37.65
C. $53.89
User Contributed Comments 5
| User | Comment |
|---|---|
| danlan2 | B2=B0*(1+0.22*0.75)^2=27.5*1.165^2=37.32 RI3=(ROE-r)B2=0.13*37.32=4.85 |
| LloydBraun7 | It was never mentioned that the book value was all equity....it would have to be in order to be able to do ROE*BV. |
| Alena1989 | In Step 2 it should be BBV in the year 2 not 3 (preceding the year of the earnings used in calculation) |
| davidt876 | nice danlan. also the answer is wrong for saying RI3 = E3 - r*BBV3... it should instead be RI3 = E3 - r*BBV2 - which is what danlan references in his answe |
| michaelcfa | The answer is correct. To calculate the residual income of period 3 (RI3) you should use the beginning book value at the end of period 2 , which is also the value at the beginning of period 3: BBV3 (37.33)! |
I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.
Andrea Schildbach
Learning Outcome Statements
compare residual income models to dividend discount and free cash flow models;
explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company's common stock;
CFA® 2025 Level II Curriculum, Volume 4, Module 24.