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Stage 2 Questions
7. Compute EnCom’s ROE for each of the five periods
using each of the above three accounting methods.
Explain how each of the different accounting methods
Stage 2 Questions
8. Using the insights from the EnCom example, provide
a qualitative explanation of the impact of aggressive
and conservative accounting on a firm’s ROE relative
to its IRR.
Stage 3 Questions
1. Provide a separate residual income valuation
for EnCom immediately after the start of
business using each of the three accounting
methods from Stage 2.
Solution (double click to see computations)
0 1 2 3 4 5 6
Residual Income Valuation (expense marketing costs as incurred)
Residual Income -42 218 238 108 128 -60
Discounted Residual Income -38.18 180.17 178.81 73.77 79.48 -33.87
Residual Income Valuation 2,160.17
0 1 2 3 4 5 6
Residual Income Valuation (amortizing marketing costs over 3 years)
Residual Income 158 98 128 108 128 -60
Discounted Residual Income 143.64 80.99 96.17 73.77 79.48 -33.87
Residual Income Valuation 2,160.17
0 1 2 3 4 5 6
Residual Income Valuation (write-off marketing costs in year 4)
Residual Income 258 188 208 -222 128 -60
2. In question 1 above, you should have arrived at the
same valuation regardless of the accounting method
employed. Provide a qualitative explanation as to
why the different accounting methods have no impact
on the valuation.
Exploiting Information in Accruals:
Sloan (1996)
⚫Accruals represent the difference between earnings
and cash flows, so earnings consists of an ‘accrual
component’ and a ‘cash flow component’.
⚫Accruals are the less reliable component of earnings,
and represent the component that is typically used to
manage/manipulate earnings:
