Finance Chapter on Growth Rates

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Questions and Answers

What condition is imposed regarding the growth rate of book value of equity?

It must grow at a rate less than R. (correct)

It must grow at a rate equal to R.

It must decrease over time.

It must grow at a rate greater than R.

According to the assumptions, which models are considered mathematically equivalent?

CAPM and APT.

PVED and CAPM.

RIV and DCF.

PVED and RIV. (correct)

What is the coefficient on the book value of equity in the RIV model?

Greater than one.

Zero.

Negative one.

One. (correct)

What does the RIV model link value to?

Observable accounting data. Signup and view all the answers

Which of the following is a restriction imposed by the RIV model?

Clean surplus as the sole restriction. Signup and view all the answers

What is the characteristic of the coefficients on expected abnormal earnings in the RIV model?

They follow a geometric series. Signup and view all the answers

What does the model suggest about accounting systems in relation to RIV?

Any accounting system that satisfies CSR will work. Signup and view all the answers

What is implied if PVED is false?

RIV must also be false. Signup and view all the answers

What is the main focus of the literature referenced by Verrecchia regarding firm value?

The significance of summarizing firm value in terms of earnings and assets. Signup and view all the answers

How do Ohlson’s model and Gordon’s dividend growth model relate?

They share similar initial assumptions regarding present value of expected dividends. Signup and view all the answers

In the Gordon model, what does the symbol φ represent?

The portion of earnings that are retained by the firm. Signup and view all the answers

What does the Gordon model primarily assume about corporate earnings?

Earnings will yield a constant return on the equity book value. Signup and view all the answers

What assumption does Gordon and Shapiro’s model overlook?

The explicit treatment of uncertainties in earnings projections. Signup and view all the answers

What does the regression equation presented in the document aim to explain?

The relationship between short-term and long-term earnings Signup and view all the answers

Which factor is highlighted as significantly influencing the values of the coefficients and R2 in the regression model?

Variance of the unobserved changes in earnings ($, ∆Tit$) Signup and view all the answers

What effect does serial correlation in abnormal earnings have on regression coefficients according to the document?

It leads coefficients to deviate from their theoretical values Signup and view all the answers

What bias is mentioned as a possible reason for Bernard's lower R2 value compared to the RIV model?

Bias related to unscaled variables in the estimation Signup and view all the answers

What is the significance of covariances in the context of the regression model discussed?

They enhance the regression R2 by capturing information from omitted variables Signup and view all the answers

What theoretical benchmark is associated with testing RIV in the context of Abarbanell and Bernard's study?

The expected alignment with long-term earnings forecasts Signup and view all the answers

What conclusion did Abarbanell and Bernard reach regarding the U.S. stock market's evaluation of earnings?

It undervalues long-term earnings in relation to short-term earnings Signup and view all the answers

What role does measurement error in proxies for expectations play in regression analysis according to the document?

It reduces the explanatory power of the regression model Signup and view all the answers

What does the Feltham-Ohlson model primarily differentiate between in a firm's net assets?

Financial and operating assets Signup and view all the answers

According to the Feltham-Ohlson model, what is always assumed for abnormal earnings related to financial assets?

It is always zero Signup and view all the answers

Which equation in the Feltham-Ohlson model represents the dynamics of book value?

bt +1 = δ2 bt + ν2 , t + ε 2 , t +1 Signup and view all the answers

In the context of the Feltham-Ohlson model, what does the parameter δ1 indicate?

Level of accounting conservatism Signup and view all the answers

What distinguishes the Feltham-Ohlson model's dynamics from the earlier models according to the provided content?

Dependence of abnormal earnings on book value Signup and view all the answers

Which descriptor accurately reflects the constraint on the coefficients γ1 and γ2 in the Feltham-Ohlson model?

They must be less than 1 in absolute value Signup and view all the answers

Which of the following equations is responsible for the time evolution of abnormal earning dynamics in the Feltham-Ohlson model?

ν1,t +1 = γ1ν1, t + η1, t +1 Signup and view all the answers

What can be inferred about financial assets in the context of the Feltham-Ohlson model?

They facilitate value creation of operating assets Signup and view all the answers

What is the relationship between book value at time t+1 and book value at time t?

bt+1 = (1 + g)bt Signup and view all the answers

In the equations provided, what does the variable g represent?

The growth rate Signup and view all the answers

According to the Gordon growth model, which of the following is true about abnormal earnings?

Abnormal earnings are calculated as x t+1 - rbt. Signup and view all the answers

What effect does incorporating an error term into the model have on dividend policy?

It suggests payouts should equal expected earnings plus an innovation term. Signup and view all the answers

What does φ represent in the equations regarding dividends and earnings?

The retention ratio Signup and view all the answers

How is the growth in dividends at time t+1 expressed in relation to dividends at time t?

dt+1 = (1 + g) dt Signup and view all the answers

What assumption does Gordon's model typically make regarding future growth?

Growth rate is assumed to be non-negative. Signup and view all the answers

In the context of earnings and book value relationship, which statement is true?

Earnings depend on realized values, ensuring clean surplus is maintained. Signup and view all the answers

Study Notes

Key Assumptions and Models

The growth rate is denoted by ( g = φρ ), impacting book value, earnings, and dividends.
Equational relationships are established for the evolution of book value, earnings, and dividends:
- ( bt + 1 = (1 + g) bt )
- ( x t + 1 = (1 + g) x t )
- ( d t + 1 = (1 + g) d t )
The abnormal earnings dynamic in the Gordon growth model simplifies to ( x ta + 1 = (1 + g) x ta ).

Gordon vs. Ohlson Model

Gordon's model assumes ( g ≥ 0 ), while Ohlson's model includes an information factor ( νt ).
Clean surplus accounting must hold, relying on realized earnings for calculations.
A regularity condition is established where the book value of equity grows at a rate less than ( R ).

Present Value of Expected Dividends (PVED)

PVED is rewritten as a function of book value and discounted expected abnormal earnings:
- ( p t = bt + ∑ R -τ E_t (x ta + τ) ).
PVED and the Residual Income Valuation (RIV) models are mathematically equivalent.
Rejection of RIV implies rejecting the hypothesis that future cash flows impact security pricing.

Empirical Implications of RIV

Stock prices are defined as a linear function of book value of equity and expected abnormal earnings.
The coefficient on book value is unity; coefficients on expected abnormal earnings follow a geometric series.
RIV indicates that clean surplus is the only restriction on the accounting system used.

Feltham-Ohlson Model Extension

The Feltham-Ohlson Model (FOM) evaluates financial and operating assets separately, assuming financial assets are fairly valued.
FOM focuses on operating assets while maintaining the PVED and RIV structures.
The model introduces equations for the dynamics of abnormal earnings, book value, and innovations in earnings.

Testing RIV

Deriving an appropriate benchmark for testing RIV faces challenges due to unobserved variances and measurement errors.
Empirical studies, like those by Abarbanell and Bernard (1994), assess if the stock market values short-term earnings too highly compared to long-term earnings.
Issues arise when relating RIV back to empirical observations, often leading to coefficients being statistically below expected values for long-term earnings predictions.

Relation to Gordon Model

Ohlson’s model relates closely to Gordon’s dividend growth model, despite differing initial expressions.
Both models' assumptions involve processes for earnings and dividends, and assume Clean Surplus Relationship (CSR).
Gordon's equations reveal relationships among dividends, earnings retention ratio ( φ ), and book return on equity ( ρ ).

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Description

This quiz explores the evolution of book value, earnings, and dividends as influenced by growth rates. Key formulas are presented to illustrate the relationships between these financial metrics. Test your understanding of the concepts related to growth in finance.