- CFA Exams
- CFA Level I Exam
- Study Session 11. Equity Valuation (3)
- Reading 30. Residual Income Valuation
- Subject 1. Calculating residual income

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**CFA Practice Question**

An analyst gathers the following data for a company (all data in $MM):

- Total assets: $380.
- Debt: $114.
- Pretax cost of debt: 5%.
- Equity (26.6 million shares outstanding): $266.
- Cost of equity: 14%.
- EBIT: $45.
- Marginal tax rate: 40%

The residual income of the company using equity charge method is:

A. -$12.8.

B. -$10.4.

C. -$13.6.

**Explanation:**We calculate net income first:

Using the equity charge method, we calculate residual income:

Equity charge = Equity x cost of equity = $266 x 0.14 = $37.2.

Residual income = Net income - Equity charge = $(13.6)

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**User Contributed Comments**
2

User |
Comment |
---|---|

americade |
The Capital Charge method results in the same Residual Income, I tried both methods. |

b25331 |
A fast alternative method: Calculate NOPAT: EBIT x (1-t) = 27 Divide NOPAT by TA: 27/380 = 7.11% Calculate WACC: 10.70 Difference in returns: 7.11%-10.70% = -3.59% Since NOPAT-to-Assets is lower than WACC, economic value is deteriorating, i.e. residual income less than zero. Residual income is then equal to: -3.59% x TA = -13.64 |