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Modelling excess profit

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  • Magni, Carlo Alberto

Abstract

This paper deals with the problem of modelling in a formal way the concept of excessprofit, also known as residual income. A common idea is that excess profit is an unequivocalconcept, being the diference between profit and costs, where all types of costs are taken into account, included the opportunity cost, i.e. the profit the entrepreneur would obtain if she invested in another business. This paper aims at showing that this diference is not univocal and that diferent approaches may be followed to give voice to such a notion. It turns out that two diferent interpretations are possible. The one existing in the literature is well described by Preinrich (1938), Edwards and Bell (1961) and, more recently, by Peasnell (1981, 1982) in the accounting literature and by Stewart (1991) in the value-based management literature. The interpretation here provided gives rise to a diferent way of modelling the notion of excess profit. While the existing models are tied to the financial literature, the model here presented is more akin to a microeconomic perspective. The paper focuses on the formal relations among the various models and necessary and sufficient conditions are provided for the integration of all models in the systemic framework here adopted. Furthermore, it shows that the systemic paradigm enjoys an aggregation property which makes residual incomes aggregate in a value sense and enables one to reduce forecasting errors in valuation.

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Bibliographic Info

Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 21 (2004)
Issue (Month): 3 (May)
Pages: 595-617

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Handle: RePEc:eee:ecmode:v:21:y:2004:i:3:p:595-617

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Web page: http://www.elsevier.com/locate/inca/30411

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References

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  1. Kay, John A, 1976. "Accountants, Too, Could Be Happy in a Golden Age: The Accountant's Rate of Profit and the Internal Rate of Return," Oxford Economic Papers, Oxford University Press, vol. 28(3), pages 447-60, November.
  2. Daniel Teichroew & Alexander A. Robichek & Michael Montalbano, 1965. "Mathematical Analysis of Rates of Return Under Certainty," Management Science, INFORMS, vol. 11(3), pages 395-403, January.
  3. Carlo Alberto Magni, 2003. "Decomposition of Net Final Values: Systemic Value Added and Residual Income," Bulletin of Economic Research, Wiley Blackwell, vol. 55(2), pages 149-176, 04.
  4. Daniel Teichroew & Alexander A. Robichek & Michael Montalbano, 1965. "An Analysis of Criteria for Investment and Financing Decisions Under Certainty," Management Science, INFORMS, vol. 12(3), pages 151-179, November.
  5. Gronchi, Sandro, 1986. "On Investment Criteria Based on the Internal Rate of Return," Oxford Economic Papers, Oxford University Press, vol. 38(1), pages 174-80, March.
  6. Gary C. Biddle & Robert M. Bowen & James S. Wallace, 1999. "Evidence On Eva," Journal of Applied Corporate Finance, Morgan Stanley, vol. 12(2), pages 69-79.
  7. Magni, Carlo Alberto, 2002. "Investment decisions in the theory of finance: Some antinomies and inconsistencies," European Journal of Operational Research, Elsevier, vol. 137(1), pages 206-217, February.
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Cited by:
  1. Magni, Carlo Alberto, 2004. "Rating and ranking firms with fuzzy expert systems: the case of Camuzzi," MPRA Paper 5889, University Library of Munich, Germany.
  2. Magni, Carlo Alberto, 2003. "Opportunity cost, excess profit, and counterfactual conditionals," MPRA Paper 5695, University Library of Munich, Germany.
  3. Carlo Alberto Magni, 2007. "A Sum&Discount Method for Appraising Firms: An Illustrative Example," Department of Economics 572, University of Modena and Reggio E., Faculty of Economics "Marco Biagi".
  4. Magni, Carlo Alberto, 2007. "Residual income and value creation: An investigation into the lost-capital paradigm," MPRA Paper 7335, University Library of Munich, Germany.
  5. Magni, Carlo Alberto, 2005. "Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I," MPRA Paper 7359, University Library of Munich, Germany, revised 27 Feb 2008.
  6. Magni, Carlo Alberto, 2009. "Splitting up value: A critical review of residual income theories," European Journal of Operational Research, Elsevier, vol. 198(1), pages 1-22, October.
  7. magni, Carlo Alberto, 2006. "Zelig and the Art of Measuring Excess Profit," MPRA Paper 5663, University Library of Munich, Germany.
  8. Carlo Magni, 2005. "On Decomposing Net Final Values: Eva, Sva and Shadow Project," Theory and Decision, Springer, vol. 59(1), pages 51-95, 08.

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