Question

Explain the concept behind the Residual Operating Income (ROPI) model.

Answer 1

Residual Income model is based on the idea that the value of equity of the firm is equal to the present value of future residual income discounted at the cost of equity.

Here, cost of equity or required rate of return need to be determined based on the CAPM model i.e

Cost of equity= Risk Free Rate+Beta*Risk Premium

Say, a company has distributes dividend D for current year and it is expected to grow at g for next year onwards

Hence, as per ROPI model value of equity= D*(1+g)/(Cost of equity-g)