The chapters in this document are displayed in reversed order, with the last chapter
appearing first. This change ensures all chapters are included in the Solutions.
Chap 1 to 12 Plus Appx A,D,E Included ✅
Chapter 12
Using Accounting Information
in Equity Valuation
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses
Difficulty Rating for Exercises and Problems:
Easy: E12.10; E12.11; E12.13
Medium: E12.12; E12.14; E12.15, E12.21; E12.22; E12.23
P12.31, P12.32
Difficult: E12.16; E12.17; E12.18; E12.19; E12.20
P12.24; P12.25; P12.26; P12.27; P12.28; P12.29; P12.30; P12.33; P12.34; P12.35;
P12.36
QUESTIONS
Q12.1 Discounted Cash Flow Versus Residual Income Valuation.
The discounted cash flow method to equity valuation encompasses several cash-based valuation
approaches. One discounted cash flow approach estimates firm value by discounting the free
cash flow to all investors in a business (i.e., both debt and equity investors) and then subtracts
the debt of a business to arrive at the equity value of the firm. A somewhat less complicated,
more direct approach is discussed in Chapter 12. This discounted cash flow approach calculates
the free cash flow distributed to the equity investors only and then discounts these cash flows
using the cost of equity. The general steps followed in this approach can be summarized as
follows:
1. Prepare pro forma financial statements for the specific forecast period.
2. Calculate the free cash flow to equity and discount these flows using the cost of equity.
3. Estimate a firm’s terminal value (TV) and discount the TV using the firm’s cost of equity.
4. Aggregate the discounted free cash flows from step two and the discounted terminal
value from step three to obtain the equity value of the firm.
5. Divide the equity value calculated in step four by the number of outstanding shares to
arrive at the equity value per share.
continued
© 2026
Solutions Manual, Chapter 12 12-1
, The residual income (RI) model is a valuation approach based on accrual earnings instead of
cash flow. The general steps followed in RI valuation can be summarized as follows:
1. Prepare pro forma financial statements for the specific forecast period.
2. Calculate the residual income for the specific forecast period by subtracting a firm’s
normal earnings (e.g., the cost of equity x common shareholders’ equity as of the
beginning of the period) from its forecasted earnings.
3. Discount the excess earnings calculated in step two by the firm’s cost of equity.
4. Estimate a firm’s terminal value (i.e., terminal year residual income / cost of equity less
assumed growth rate) and discount the TV at the cost of equity.
5. Aggregate the present value of the residual income from step three and the present value
of the TV obtained in step four to get the equity value of the firm. Divide by the number
of shares outstanding to calculate the equity value per share.
The DCF model is based on the idea that only realized cash available to be distributed back to
shareholders determine value. The RI model is derived from the basic financial tenet that a
company only adds value to its shareholders if it is able to earn a return greater than its cost of
capital. The DCF model and the RI model are mathematically equivalent and will yield equivalent
valuation results provided equivalent assumptions are used to prepare the pro forma financial
statements and the same interest rate is used to discount the respective flows.
Q12.2 Pro Forma Financial Statements.
Pro forma financial statements are “as if” financial statements reflecting management’s
expectations regarding a firm’s future performance. The process used to build pro forma financial
statements often proceeds as follows:
1. Forecast sales on the income statement.
2. Forecast cost of goods sold and operating expenses.
3. Forecast the working capital accounts on the balance sheet.
4. Forecast property, plant and equipment and any intangible assets.
5. Forecast depreciation and amortization expense.
6. Forecast the financing of any new capital expenditures.
7. Forecast interest expense on the income statement.
8. Complete the forecasted income statement and link the net income (loss) to retained
earnings on the balance sheet.
9. Forecast any dividend payments.
10. Estimate a growth rate to forecast the terminal value.
11. Build a statement of cash flow using the indirect method from the pro forma income
statement and balance sheets.
The final step concerns the preparation of a pro forma statement of cash flow. Since this information
can be constructed from the pro forma income statements and balance sheets using the indirect
method, it is unnecessary to make any further assumptions about a firm’s future cash flow.
Both the discounted cash flow model and the residual income model compute valuations by
discounting a series of future streams, either free cash flow or residual income. Rather than trying
to compute an infinite stream, a shortcut method is utilized. The shortcut involves limiting the
discounting process to a few years and then computing a terminal value and using a formula to
compute the present value beyond the terminal value by using a formula for a growing perpetuity.
© 2026
12-2 Financial Accounting for Executives & MBAs, 6th Edition
,Q12.3 Free Cash Flow versus Residual Income.
Free cash flow (FCF) is defined as the cash flow from operations (CFFO) less any cash outflow
for capital expenditures. Residual income (RI), on the other hand, is defined as a firm’s excess
earnings (i.e., its net income less its normal earnings). Over the life of a business, the sum of the
free cash flow and the sum of the residual income will be equivalent. In any given period,
however, it is unlikely that FCF will equal RI as a consequence of the accrual accounting process.
Q12.4 Capital Asset Pricing Model and Beta.
The Capital Asset Pricing Model (CAPM) is a widely accepted model used to estimate the cost
of equity for a firm. A key component of the CAPM is beta, which is a measure of a firm’s
systematic risk. Systematic risk refers to the extent to which a firm’s share price will increase
(decrease) with the general stock market. For instance, a firm with a beta of 1.0 will have a share
price that moves in close proximity to the direction of the general market (i.e., the correlation
between changes in the value of its share price and movements in the S&P 500 index are
perfectly correlated). A firm with a beta of 1.5 will have a share price that moves approximately
1.5 percent for a one percent move in the S&P 500 index.
Q12.5 Analyzing and Reporting Operating Loss Carryforwards.
The existence of operating loss carryforwards may be a significant source of value for a business,
because they may be used to offset future income taxes. In the case of General Electric, its
$2,799 million in operating loss carryforwards could produce approximately $700 million ($2,799
million x 25 percent) in additional operating cash flow from tax savings.
The positive impact of operating loss carryforwards will be reflected in value via the company’s
future cash flow from operations and residual income (i.e., the income tax expense deducted
from net income).
Q12.6 Forecasting the Cost of Sales: Economies and Diseconomies of Scale.
Economies of scale arise when a company reaches a sufficiently high level of sales volume such
that the cost of sales per unit of output declines, causing gross profit per unit to increase. This
phenomenon typically begins to occur after a company reaches a sales volume that is sufficient
to cover its fixed costs. Thereafter, the fixed costs are spread over an increasing number of units,
lowering the fixed cost per unit.
Diseconomies of scale are the opposite. They arise when a company’s cost per unit increases
with increases in its output. Diseconomies typically arise when a company initially makes a large
investment in capital equipment. The additional overhead cost is spread over a small number of
units initially, causing the cost per unit to be higher than the cost per unit prior to the investment.
Once the new equipment comes fully online, the diseconomies of scale can be expected to
decline and eventually be replaced with economies of scale.
When forecasting the cost of sales, it is important to keep these economic concepts under
consideration. Simply forecasting the cost of sales using a constant common-size percentage of
cost of sales divided by sales ignores the impact of these concepts on firm value.
© 2026
Solutions Manual, Chapter 12 12-3
, Q12.7 Unlevering Cash Flow from Operations.
The discounted cash flow approach to valuation may be applied in two ways: (a) calculating the
free cash flow (FCF) to all investors (i.e., both debt and equity investors) or (b) calculating the
free cash flow to equity holders only. Under the first approach, to correctly calculate a company’s
FCF, it is first necessary to “unlever” the cash flow from operations (CFFO). The unlevering
process can be executed as follows:
Unlevered CFFO = Levered CFFO + i x (1-tx)
where i is a firm’s interest expense and tx is a company’s effective tax rate. Unlevering CFFO
yields a measure of cash flow as if a company were all equity financed (i.e., as if there is no debt
financing).
Under this approach to estimating value, the equity value of the company is calculated as follows:
Equity Value = PV(FCF) + PV(TV) - Debt
Q12.8 Discounting Cash Flow and Earnings.
Selecting an appropriate discount rate to discount the free cash flow to equity or the residual
income is an important decision. Possible choices include:
• The cost of debt
• The cost of equity
• A weighted average of the cost of debt and the cost of equity (i.e., the WACC)
The general rule followed when selecting a discount rate is to use that rate which best reflects
the riskiness of the cash (earnings) flow. In the case of residual income, we are considering the
excess earnings accruing only to a company’s shareholders (i.e., interest expense is deducted
in calculating residual income); thus, the appropriate discount rate is the cost of equity. In the
case of the cash flow to equity, we are again focusing only on the flows to shareholders (i.e., after
debtholders have received their cash return), and thus again, the cost of equity is the appropriate
rate.
The WACC would be an appropriate discount rate if the free cash flow were unlevered. The cost
of debt would be an appropriate discount if we were valuing only the debt of a company.
Q12.9 (Ethics Perspective) Virtue-based Approach to Ethics.
This question could lead to a discussion of the difference between emphasizing that accountants
understand the rules of professional conduct versus actually understanding ethical behavior.
Consider as one example, The Texas State Board of Public Accountancy enacted Rule 511.58
requiring that individuals who apply to take the CPA examination complete three semester hours
of ethics education. The course must include ethical reasoning, integrity, objectivity, and
independence. These represent the traits or virtues deemed necessary for an accountant to have
in order to protect the public interest. Integrity is related to personal character, attitude, and moral
obligations. As opposed to a “what-to-do” approach, integrity is a “how-to-live” approach.
Objectivity implies a rejection of moral subjectivity. Independence refers to a person as being
autonomous and self-determined. Integrity, objectivity, and independence can be thought of as
the core values needed by a professional accountant.
© 2026
12-4 Financial Accounting for Executives & MBAs, 6th Edition
appearing first. This change ensures all chapters are included in the Solutions.
Chap 1 to 12 Plus Appx A,D,E Included ✅
Chapter 12
Using Accounting Information
in Equity Valuation
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses
Difficulty Rating for Exercises and Problems:
Easy: E12.10; E12.11; E12.13
Medium: E12.12; E12.14; E12.15, E12.21; E12.22; E12.23
P12.31, P12.32
Difficult: E12.16; E12.17; E12.18; E12.19; E12.20
P12.24; P12.25; P12.26; P12.27; P12.28; P12.29; P12.30; P12.33; P12.34; P12.35;
P12.36
QUESTIONS
Q12.1 Discounted Cash Flow Versus Residual Income Valuation.
The discounted cash flow method to equity valuation encompasses several cash-based valuation
approaches. One discounted cash flow approach estimates firm value by discounting the free
cash flow to all investors in a business (i.e., both debt and equity investors) and then subtracts
the debt of a business to arrive at the equity value of the firm. A somewhat less complicated,
more direct approach is discussed in Chapter 12. This discounted cash flow approach calculates
the free cash flow distributed to the equity investors only and then discounts these cash flows
using the cost of equity. The general steps followed in this approach can be summarized as
follows:
1. Prepare pro forma financial statements for the specific forecast period.
2. Calculate the free cash flow to equity and discount these flows using the cost of equity.
3. Estimate a firm’s terminal value (TV) and discount the TV using the firm’s cost of equity.
4. Aggregate the discounted free cash flows from step two and the discounted terminal
value from step three to obtain the equity value of the firm.
5. Divide the equity value calculated in step four by the number of outstanding shares to
arrive at the equity value per share.
continued
© 2026
Solutions Manual, Chapter 12 12-1
, The residual income (RI) model is a valuation approach based on accrual earnings instead of
cash flow. The general steps followed in RI valuation can be summarized as follows:
1. Prepare pro forma financial statements for the specific forecast period.
2. Calculate the residual income for the specific forecast period by subtracting a firm’s
normal earnings (e.g., the cost of equity x common shareholders’ equity as of the
beginning of the period) from its forecasted earnings.
3. Discount the excess earnings calculated in step two by the firm’s cost of equity.
4. Estimate a firm’s terminal value (i.e., terminal year residual income / cost of equity less
assumed growth rate) and discount the TV at the cost of equity.
5. Aggregate the present value of the residual income from step three and the present value
of the TV obtained in step four to get the equity value of the firm. Divide by the number
of shares outstanding to calculate the equity value per share.
The DCF model is based on the idea that only realized cash available to be distributed back to
shareholders determine value. The RI model is derived from the basic financial tenet that a
company only adds value to its shareholders if it is able to earn a return greater than its cost of
capital. The DCF model and the RI model are mathematically equivalent and will yield equivalent
valuation results provided equivalent assumptions are used to prepare the pro forma financial
statements and the same interest rate is used to discount the respective flows.
Q12.2 Pro Forma Financial Statements.
Pro forma financial statements are “as if” financial statements reflecting management’s
expectations regarding a firm’s future performance. The process used to build pro forma financial
statements often proceeds as follows:
1. Forecast sales on the income statement.
2. Forecast cost of goods sold and operating expenses.
3. Forecast the working capital accounts on the balance sheet.
4. Forecast property, plant and equipment and any intangible assets.
5. Forecast depreciation and amortization expense.
6. Forecast the financing of any new capital expenditures.
7. Forecast interest expense on the income statement.
8. Complete the forecasted income statement and link the net income (loss) to retained
earnings on the balance sheet.
9. Forecast any dividend payments.
10. Estimate a growth rate to forecast the terminal value.
11. Build a statement of cash flow using the indirect method from the pro forma income
statement and balance sheets.
The final step concerns the preparation of a pro forma statement of cash flow. Since this information
can be constructed from the pro forma income statements and balance sheets using the indirect
method, it is unnecessary to make any further assumptions about a firm’s future cash flow.
Both the discounted cash flow model and the residual income model compute valuations by
discounting a series of future streams, either free cash flow or residual income. Rather than trying
to compute an infinite stream, a shortcut method is utilized. The shortcut involves limiting the
discounting process to a few years and then computing a terminal value and using a formula to
compute the present value beyond the terminal value by using a formula for a growing perpetuity.
© 2026
12-2 Financial Accounting for Executives & MBAs, 6th Edition
,Q12.3 Free Cash Flow versus Residual Income.
Free cash flow (FCF) is defined as the cash flow from operations (CFFO) less any cash outflow
for capital expenditures. Residual income (RI), on the other hand, is defined as a firm’s excess
earnings (i.e., its net income less its normal earnings). Over the life of a business, the sum of the
free cash flow and the sum of the residual income will be equivalent. In any given period,
however, it is unlikely that FCF will equal RI as a consequence of the accrual accounting process.
Q12.4 Capital Asset Pricing Model and Beta.
The Capital Asset Pricing Model (CAPM) is a widely accepted model used to estimate the cost
of equity for a firm. A key component of the CAPM is beta, which is a measure of a firm’s
systematic risk. Systematic risk refers to the extent to which a firm’s share price will increase
(decrease) with the general stock market. For instance, a firm with a beta of 1.0 will have a share
price that moves in close proximity to the direction of the general market (i.e., the correlation
between changes in the value of its share price and movements in the S&P 500 index are
perfectly correlated). A firm with a beta of 1.5 will have a share price that moves approximately
1.5 percent for a one percent move in the S&P 500 index.
Q12.5 Analyzing and Reporting Operating Loss Carryforwards.
The existence of operating loss carryforwards may be a significant source of value for a business,
because they may be used to offset future income taxes. In the case of General Electric, its
$2,799 million in operating loss carryforwards could produce approximately $700 million ($2,799
million x 25 percent) in additional operating cash flow from tax savings.
The positive impact of operating loss carryforwards will be reflected in value via the company’s
future cash flow from operations and residual income (i.e., the income tax expense deducted
from net income).
Q12.6 Forecasting the Cost of Sales: Economies and Diseconomies of Scale.
Economies of scale arise when a company reaches a sufficiently high level of sales volume such
that the cost of sales per unit of output declines, causing gross profit per unit to increase. This
phenomenon typically begins to occur after a company reaches a sales volume that is sufficient
to cover its fixed costs. Thereafter, the fixed costs are spread over an increasing number of units,
lowering the fixed cost per unit.
Diseconomies of scale are the opposite. They arise when a company’s cost per unit increases
with increases in its output. Diseconomies typically arise when a company initially makes a large
investment in capital equipment. The additional overhead cost is spread over a small number of
units initially, causing the cost per unit to be higher than the cost per unit prior to the investment.
Once the new equipment comes fully online, the diseconomies of scale can be expected to
decline and eventually be replaced with economies of scale.
When forecasting the cost of sales, it is important to keep these economic concepts under
consideration. Simply forecasting the cost of sales using a constant common-size percentage of
cost of sales divided by sales ignores the impact of these concepts on firm value.
© 2026
Solutions Manual, Chapter 12 12-3
, Q12.7 Unlevering Cash Flow from Operations.
The discounted cash flow approach to valuation may be applied in two ways: (a) calculating the
free cash flow (FCF) to all investors (i.e., both debt and equity investors) or (b) calculating the
free cash flow to equity holders only. Under the first approach, to correctly calculate a company’s
FCF, it is first necessary to “unlever” the cash flow from operations (CFFO). The unlevering
process can be executed as follows:
Unlevered CFFO = Levered CFFO + i x (1-tx)
where i is a firm’s interest expense and tx is a company’s effective tax rate. Unlevering CFFO
yields a measure of cash flow as if a company were all equity financed (i.e., as if there is no debt
financing).
Under this approach to estimating value, the equity value of the company is calculated as follows:
Equity Value = PV(FCF) + PV(TV) - Debt
Q12.8 Discounting Cash Flow and Earnings.
Selecting an appropriate discount rate to discount the free cash flow to equity or the residual
income is an important decision. Possible choices include:
• The cost of debt
• The cost of equity
• A weighted average of the cost of debt and the cost of equity (i.e., the WACC)
The general rule followed when selecting a discount rate is to use that rate which best reflects
the riskiness of the cash (earnings) flow. In the case of residual income, we are considering the
excess earnings accruing only to a company’s shareholders (i.e., interest expense is deducted
in calculating residual income); thus, the appropriate discount rate is the cost of equity. In the
case of the cash flow to equity, we are again focusing only on the flows to shareholders (i.e., after
debtholders have received their cash return), and thus again, the cost of equity is the appropriate
rate.
The WACC would be an appropriate discount rate if the free cash flow were unlevered. The cost
of debt would be an appropriate discount if we were valuing only the debt of a company.
Q12.9 (Ethics Perspective) Virtue-based Approach to Ethics.
This question could lead to a discussion of the difference between emphasizing that accountants
understand the rules of professional conduct versus actually understanding ethical behavior.
Consider as one example, The Texas State Board of Public Accountancy enacted Rule 511.58
requiring that individuals who apply to take the CPA examination complete three semester hours
of ethics education. The course must include ethical reasoning, integrity, objectivity, and
independence. These represent the traits or virtues deemed necessary for an accountant to have
in order to protect the public interest. Integrity is related to personal character, attitude, and moral
obligations. As opposed to a “what-to-do” approach, integrity is a “how-to-live” approach.
Objectivity implies a rejection of moral subjectivity. Independence refers to a person as being
autonomous and self-determined. Integrity, objectivity, and independence can be thought of as
the core values needed by a professional accountant.
© 2026
12-4 Financial Accounting for Executives & MBAs, 6th Edition
