Equity - Mendosa Question #5

CFA Level II Equities
#1

It’s been a long day but can anyone tell me why statement 3 is correct? I think of Residual income as RI=Net income - equity charge. Why would statement 3 be correct if it says it adjusts for all capital, debt and equity? The only thing I can think of is that Interest is subtracted from NI and then you subtract the equity charge…so you’ve adjusted for both.

Statement 1: Raman: As PRBI’s management is actively seeking opportunities to be acquired, the guideline public company method (GPCM) would be most appropriate as it establishes a value estimate based on pricing multiples derived from the acquisition of control of entire public or private companies that were acquired. Specifically, it uses a multiple that specifically relates to sales of entire companies.

Statement 2-Mendosa : We could also value PRBI using the free cash flow to equity (FCFE) model. But in order to support its rapid growth, the company is expected to significantly increase its net borrowing every year for the next three to five years, and during those years, it could have a significant dampening effect on the company’s FCFE and thus a lower value for its equity.

Statement 3-Raman : I agree. The residual income (RI) model, also called the “excess earnings method,” does not have the same weakness as the FCFE approach because residual income is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Furthermore, it makes no assumptions about future earnings and the justified P/B is directly related to expected future residual income.

In regard to the discussion on other approaches between Mendosa and Raman, which of the following statements that they make is most accurate? Statement:

Statement 3 by Raman is most accurate. The residual income model, also called the excess earnings method, does not have the same weakness as the FCFE approach, because it is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Further, it makes no assumptions about future earnings and dividend growth.

#2

I actually answered this question by eliminating statement 1 and 2 as being incorrect, statement 3 doesn’t ring a bell for me.

statement 1: GPCM is for valuing targets, not acquirers

statement 2: FCFE grows as net borrowing grows

#3

Thanks, yeah I just felt like all three were wrong. It’s frustrating to get these sorts of questions…they’ve drilled it into your head that RI=NI - equity charge and then they throw debt in there and I’m thinking WTF.

#4

This might clear it up a little…still a poorly worded question.

got this from #6 in Equity - vitality

The residual income model uses accounting income estimates and assumes that the cost of debt capital is properly reflected by interest expense, but because of changing market conditions, interest expense may not be a good proxy for the company’s cost of debt capital.