CFA Level II ExamEquity InvestmentsMedium
An equity analyst is using the residual income model to value a company. The company's current book value per share is $50. The required rate of return on equity is 10%. The company is expected to generate an EPS of $6 for the next year. What is the residual income per share for the next year?
- A$1.50
- B$2.00
- C$1.00
- D$2.50
Show answer & explanationAnswer & explanation
Correct answer: C. $1.00
Residual Income (RI) = Earnings Per Share (EPS) - (Required Rate of Return on Equity * Beginning Book Value Per Share). RI = $6.00 - (0.10 * $50.00) = $6.00 - $5.00 = $1.00.
Why the other options are wrong
- A. Incorrect calculation.
- B. Incorrect calculation.
- D. Incorrect calculation.
Residual Income (RI)
The earnings of a company that exceed the investors' required rate of return on the company's equity capital. It represents the profit generated after covering the cost of equity.
- RI = Net Income - (Equity Capital * Cost of Equity).
- Used in the Residual Income Model for equity valuation.
- Can be positive (value creation) or negative (value destruction).
Memory trick: Earnings MINUS Cost of Equity equals Residual Income.