R19.3 Residual Income Approach

CFA Level II Corporate Finance
#1

Hi,

I’m studying at Kaplan and come across the residual income approach to calculate company value.
The general formula is Residual Income = Net Income - Equity Charge

  • Equity Charge = Beginning Book Value of Equity * Cost of Equity
    The way that we calculate the Beg. BV of Equity is by using accounting equation Assets = Liabilities + Equity
    The things I do not get it here is the calculation for Liabilities, which it is calculated based on market value of project, which is the future cash inflows.
    In that sense, assuming my future cash inflows to be 10times higher than estimated, my liabilities would be far more high than my assets, which result me in net liabilities, where the amount of my borrowings to finance the initial investment is still the same.
    Does this make sense? It simply means that the higher future cash inflow I have, the higher my liabilities I have.
    Is there anything wrong or misconception here?
#2

If I have understood correctly, your liability even if publicly traded do not have upside potential unless of course :slight_smile:

  1. You had to refinance
  2. Your overall company prospect deteriorated
  3. Market interest rate increased thereby your floating rate liability experiencing higher interest cost

A = L + E must hold ( clean surplus). Foreign currency convertibility or subsidiary consolidation of violate clean surplus then RI is an erroneous tool to apply. So either fix those potential irritants and then hold the clean surplus or don’t apply at all.

Again think of liability with capped faced value with 0 upside potential. But for obvious reason your BV and MV of debt will be near equal.