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Residual income and value creation: An investigation into the lost-capital paradigm

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  • Magni, Carlo Alberto

Abstract

This paper presents a new way of measuring residual income, originally introduced by Magni (2000a,b,c, 2001a,b, 2003). Contrary to the standard residual income, the capital charge is equal to the capital lost by investors multiplied by the cost of capital. The lost capital may be viewed as (a) the foregone capital, (b) the capital implicitly infused into the business, (c) the outstanding capital of a shadow project, (d) the claimholders' credit. Relations of the lost capital with book values and market values are studied, as well as relations of the lost capital residual income with the classical standard paradigm; many appealing properties are derived, among which an aggregation property. Different concepts and results, provided by different authors in such different fields as economic theory, management accounting and corporate finance, are considered: O'Hanlon and Peasnell's (2002) unrecovered capital and Excess Value Created; Ohlson's (2005) Abnormal Earnings Growth; O'Byrne's (1997) EVA improvement; Miller and Modigliani's (1961) investment opportunities approach to valuation; Young and O'Byrne's (2001) Adjusted EVA; Keynes's (1936) user cost; Drukarczyk and Schueler's (2000) Net Economic Income; Fernández's (2002) Created Shareholder Value; Anthony's (1975) profit. They are all conveniently reinterpreted within the theoretical domain of the lost-capital paradigm and conjoined in a unified view. The results found make this new theoretical approach a good candidate for firm valuation, capital budgeting decision-making, managerial incentives and control.

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Bibliographic Info

Article provided by Elsevier in its journal European Journal of Operational Research.

Volume (Year): 201 (2010)
Issue (Month): 2 (March)
Pages: 505-519

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Handle: RePEc:eee:ejores:v:201:y:2010:i:2:p:505-519

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Web page: http://www.elsevier.com/locate/eor

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Keywords: Accounting Corporate finance Residual income Value creation Management Incentive compensation Lost-capital Net Present Value Book value Market value;

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References

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  1. P. H. Karmel, 1959. "The Marginal Efficiency Of Capital," The Economic Record, The Economic Society of Australia, vol. 35(72), pages 429-434, December.
  2. magni, Carlo Alberto, 2006. "Zelig and the Art of Measuring Excess Profit," MPRA Paper 5663, University Library of Munich, Germany.
  3. Magni, Carlo Alberto, 2007. "Relevance or irrelevance of retention for dividend policy irrelevance," MPRA Paper 5591, University Library of Munich, Germany.
  4. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411.
  5. Stephen F. O'Byrne & S. David Young, 2006. "Incentives and Investor Expectations," Journal of Applied Corporate Finance, Morgan Stanley, vol. 18(2), pages 98-105.
  6. Carlo Alberto Magni, 2009. "Modeling excess profit," PROYECCIONES FINANCIERAS Y VALORACION 005522, MASTER CONSULTORES.
  7. Magni, Carlo Alberto, 2000. "Systemic Value Added, Residual Income and Decomposition of a Cash Flow Stream," MPRA Paper 5900, University Library of Munich, Germany.
  8. James E. Walter, 1956. "Dividend Policies And Common Stock Prices," Journal of Finance, American Finance Association, vol. 11(1), pages 29-41, 03.
  9. 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.
  10. Carlo Alberto Magni, 2009. "Opportunity Cost, Excess Profit, and Counterfactual Conditionals," Frontiers in Finance and Economics, SKEMA Business School, vol. 6(1), pages 118-154, April.
  11. DeAngelo, Harry & DeAngelo, Linda, 2006. "The irrelevance of the MM dividend irrelevance theorem," Journal of Financial Economics, Elsevier, vol. 79(2), pages 293-315, February.
  12. Roberto Ghiselli Ricci & Carlo Alberto Magni, 2009. "Economic value added and systemic value added: symmetry, aditive coherence and differences in performance," PROYECCIONES FINANCIERAS Y VALORACION 005736, MASTER CONSULTORES.
  13. 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.
  14. Weaver, Samuel C. & Weston, J. Fred, 2003. "A Unifying Theory of Value Based Management," University of California at Los Angeles, Anderson Graduate School of Management qt0xw5m9mz, Anderson Graduate School of Management, UCLA.
  15. 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.
  16. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
  17. Carlo Magni, 2005. "On Decomposing Net Final Values: Eva, Sva and Shadow Project," Theory and Decision, Springer, vol. 59(1), pages 51-95, 08.
  18. Diran Bodenhorn, 1959. "On The Problem Of Capital Budgeting," Journal of Finance, American Finance Association, vol. 14(4), pages 473-492, December.
  19. Magni, Carlo Alberto, 2000. "Decomposition of a Certain Cash Flow Stream: Differential Systemic Value and Net Final Value," MPRA Paper 7308, University Library of Munich, Germany.
  20. Magni, Carlo Alberto, 2005. "On decomposing net final values: EVA, SVA, and shadow project," MPRA Paper 12357, University Library of Munich, Germany.
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Cited by:
  1. repec:rej:journl:v:15:y:2012:i:45:p:3-26 is not listed on IDEAS
  2. Carlo Alberto, Magni, 2008. "Splitting Up Value: A Critical Review of Residual Income Theories," MPRA Paper 10506, University Library of Munich, Germany.
  3. Hechmi Soumaya, 2013. "Eva versus Other Performance Measures," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 3(4), pages 532-541, April.
  4. Ghiselli Ricci, Roberto & Magni, Carlo Alberto, 2009. "Axiomatization of residual income and generation of financial securities," MPRA Paper 14438, University Library of Munich, Germany.

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