Chartered Financial Analyst (CFA) Practice Exam Level 2

How is the Residual Income calculated based on the given formula?

1. RI = Earnings - Tax expenses

2. RI = Net Income - (Equity * ROE)

3. RI = Gross Profit - Operating Expenses

4. RI = Cash Flows - Interest Payments

The correct answer is: RI = Net Income - (Equity * ROE)

The correct method of calculating Residual Income is through the formula RI = Net Income - (Equity * ROE). This approach emphasizes the importance of measuring the performance of a company beyond just basic earnings. Residual Income represents the amount of income earned in excess of the minimum required return on equity. In this context, Net Income serves as the actual earnings generated by the company, while the term (Equity * ROE) measures the expected return based on the equity capital invested and the company's rate of return on equity. If the Net Income exceeds this required amount, it indicates that the company is generating value for its shareholders beyond what they could expect given the risk associated with the equity. This formula allows investors and analysts to assess how well the company is performing in terms of creating value over and above the cost of equity, providing a more nuanced understanding of profitability. It is a central concept in valuation methodologies and performance measurement in finance. The other options do not accurately reflect the Residual Income calculation. For instance, calculating RI using earnings minus tax expenses does not consider the required return on equity, while gross profit minus operating expenses is related to operational profitability, which is different from residual income. Additionally, cash flows minus interest payments relate more to cash flow