- CFA Exams
- CFA Exam: Level II 2021
- Study Session 10. Equity Valuation (2)
- Reading 27. Discounted Dividend Valuation
- Subject 1. Streams of expected cash flows

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**CFA Practice Question**

Which of the following statements is (are) true with respect to the use of the various measures of cash flow when performing valuation calculations?

II. If the investor exerts a considerable influence on the firm's decision making process, then, free cash flow would be a better measure of cash flow than dividends.

III. The residual income model assumes that the value of the stock should be its book value plus or minus an adjustment that's equal to the present value of all future residual income amounts on a pro rata basis.

IV. The most practical of all the measures of cash flow is dividends.

I. Free cash flow measures can only be used to calculate the total value of the firm that's available to both bondholders and stockholders.

II. If the investor exerts a considerable influence on the firm's decision making process, then, free cash flow would be a better measure of cash flow than dividends.

III. The residual income model assumes that the value of the stock should be its book value plus or minus an adjustment that's equal to the present value of all future residual income amounts on a pro rata basis.

IV. The most practical of all the measures of cash flow is dividends.

Correct Answer: II and III

I is incorrect because free cash flow measures can be used to first calculate the total value of the firm, and then, by subtracting the market value of the debt, the value available to stockholders may be derived.

IV is incorrect. Using dividends as a proxy for cash is mostly suitable for companies that have an established dividend policy. The important thing to keep in mind is that the proxy that is chosen for cash must be met with an equally suitable measure for the discount rate.

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**User Contributed Comments**
3

User |
Comment |
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letg |
why III is right? |

NillePet |
the formula for the residual income model: V=B(t)+RI(t)/R-G whereas: R = required rate G = growth B(t) - BV at time t RI - Residual Income at time t: RI=E(t)-R*B(t-1) E(t) - Earnings at time t B(t-1) - BV at time t-1 |

davidt876 |
i didn't get why they had to include "pro rata" at the end of III |