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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)! |
Thanks again for your wonderful site ... it definitely made the difference.
Craig Baugh
Learning Outcome Statements
explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects;
CFA® 2025 Level II Curriculum, Volume 4, Module 24.