Question

a. Major disadvantage of residual income approach is It can be used to compare performance of divisions of same sizes b. It can be used to compare performance of divisions of different sizes It cannot be used to compare performance of divisions of same sizes d. It cannot be used to compare performance of divisions of different sizes C. Select one: a. It cannot be used to compare performance of divisions of different sizes O b. It can be used to compare performance of divisions of same sizes O c. It can be used to compare performance of divisions of different sizes O d. It cannot be used to compare performance of divisions of same sizes

Answer 1

Answer to the MCQ Questions are -

1. Major disadvantage of residual income approach is -

The answer to above part is option (a)(in select option) i.e. It cannot be used to compare performance of divisions of different sizes.

First let us see What is residual income approach. So Residual income valuation is an equity valuation method based on the premise that the value of a company's stock equals the present value of future residual incomes discounted at the appropriate cost of equity

.The explanation of the answer is Residual income approach is an absolute measure of return so it makes difficult to directly compare the performance of different divisions. For eg - If you are comparing two divisions A & B, where their residual income is USD 300,000 and USD 100,000. On the first look, it appears Division A is better, but this is not right as we also need to see the amount of assets involved in generating this residual income. Therefore this explantion negates all other options.

2. NPV (Net Present value) is involved with -

The answer of the above question is (c)(in select option) i.e. Cash Flow not accounting income.

NPV is basically the present value of all cash inflows and outflows based out of project. It is not related to accounting income. So for calculation of NPV you only need the cashflows associated with the project. The cashflows could be - Inital cost of project, Subsequent cash inflows from the project, terminal cash flows for the project and residual value if any.

3. Accounting Net Income is based on accruals which -

The answer of the above question is (b)(in select option) i.e. Includes timing of cash flows.

Accrual concept of accounting involves recording of transaction on basis of accrual basis instead of actual basis. This can be better explained with following example. For eg - Company A sells to Company B a certain product to which company B agreed to pay one month later. Now the company A has two ways to record this transaction-

If the company record it on actual/receipt basis then the company will not enter any transaction into its books of accounts and will enter the transaction only after the cash for the product is recieved.

However under accrual basis, the transaction is recorded the moment it occurs irrespective of cash receipt or payment. Therefore for the answer of this question, the answer is that it includes the timing of cash flows.

Hope it is clear.

Thank You