Question

3. What is the principle assumption that allows an analyst to modify a residual earnings (RE) model to a residual operating earnings (ReOI) model? In your answer, explain the primary benefit of a ReOI model over the RE model. (5 points)

Answer 1

1) To understand why analysts modify a residual earning (RE) model to a residual operating earnings (ReOI) model, let us identify the pros of a ReOI model over a RE model

• ReOI = Net Profit After Tax _t - (Weighted Average Cost of Capital * Net Operating Asset _t-1)
• This equation works with an after-tax cost of debt since dividend payments are not tax deductible whereas interest expense is. However, the Residual Income model does not account for dividend payments
• The ReOI model, unlike the RE method, does not rely heavily on forward-looking estimates of a firm's financial statement, which eliminates the possibility for historical and even psychological baises to affect the interpretation of the statements.
• Unlike Residual earning, ReOI model is not an absolute measure of profitability, hence there is no direct comparison for investments on a different level
• The RE model is vulnerable to management accounting manipulation but ReOI model is not vulnerable to such malpractice
• For analysts, an In depth understanding of Public Financial Reporting is not required for ReOI model but is required for RE model for s large adjustments to reported financials
• Unlike ReOI the RE model has a major disadvantage that it requires the clean surplus relation to holds, or the analysts need to make adjustments when the clean surplus relation does not hold