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Splitting Up Value: A Critical Review of Residual Income Theories

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Author Info
Carlo Alberto, Magni

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Abstract

This paper deals with the notion of residual income, which may be defined as the surplus profit that residues after a capital charge (opportunity cost) has been covered. While the origins of the notion trace back to the 19th century, in-depth theoretical investigations and widespread real-life applications are relatively recent and concern an interdisciplinary field connecting management accounting, corporate finance and financial mathematics (Peasnell, 1981, 1982; Peccati, 1987, 1989, 1991; Stewart, 1991; Ohlson, 1995; Arnold and Davies, 2000; Young and O'Byrne, 2001; Martin, Petty and Rich, 2003). This paper presents both a historical outline of its birth and development and an overview of the main recent contributions regarding capital budgeting decisions, production and sales decisions, implementation of optimal portfolios, forecasts of asset prices and calculation of intrinsic values. A most recent theory, the systemic-value-added approach (also named lost-capital paradigm), provides a dierent denition of residual income, consistent with arbitrage theory. En- folded in Keynes's (1936) notion of user cost and forerun by Pressacco and Stucchi (1997), the theory has been formally introduced in Magni (2000a,b,c; 2001a,b; 2003), where its properties are thoroughly investigated as well as its relations with the standard theory; two different lost-capital metrics have been considered, for value-based management purposes, by Drukarczyk and Schueler (2000) and Young and O'Byrne (2001). This work illustrates the main properties of the two theories and their relations, and provides a minimal guide to construction of performance metrics in the two approaches.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 10506.

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Date of creation: 11 Sep 2008
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Handle: RePEc:pra:mprapa:10506

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Related research
Keywords: Finance; accounting; residual income; excess profit; net present value; opportunity cost; counterfactual; performance measurement; management;

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Find related papers by JEL classification:
D46 - Microeconomics - - Market Structure and Pricing - - - Value Theory
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
G3 - Financial Economics - - Corporate Finance and Governance
M21 - Business Administration and Business Economics; Marketing; Accounting - - Business Economics - - - Business Economics

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Cigola, Margherita & Peccati, Lorenzo, 2005. "On the comparison between the APV and the NPV computed via the WACC," European Journal of Operational Research, Elsevier, vol. 161(2), pages 377-385, March. [Downloadable!] (restricted)
  2. Magni, Carlo Alberto, 2007. "CAPM and capital budgeting: present versus future, equilibrium versus disequilibrium, decision versus valuation," MPRA Paper 5468, University Library of Munich, Germany, revised Jun 2009. [Downloadable!]
  3. Magni, Carlo Alberto, 2007. "In search of the "lost capital". A theory for valuation, investment decisions, performance measurement," MPRA Paper 5719, University Library of Munich, Germany. [Downloadable!]
  4. Ignacio Vélez Pareja & Joseph Tham, 2004. "EVA(c) Made Simple: Is it Possible?," MEDICION EVALUACION DEL VALOR 001895, POLITÉCNICO GRANCOLOMBIANO. [Downloadable!]
  5. Robert Sugden, 2000. "Credible worlds: the status of theoretical models in economics," Journal of Economic Methodology, Taylor and Francis Journals, vol. 7(1), pages 1-31, March. [Downloadable!] (restricted)
  6. Magni, Carlo Alberto, 2007. "Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM?," MPRA Paper 5471, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  7. Magni, Carlo Alberto, 2007. "Residual income and value creation: An investigation into the lost-capital paradigm," MPRA Paper 7335, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  8. Richard P. Brief, 2007. "Accounting Valuation Models: A Short Primer," Abacus, Accounting Foundation, University of Sydney, vol. 43(4), pages 429-437. [Downloadable!] (restricted)
  9. Carlo Alberto Magni, 2003. "Decomposition of Net Final Values: Systemic Value Added and Residual Income," Bulletin of Economic Research, Blackwell Publishing, vol. 55(2), pages 149-176, 04. [Downloadable!] (restricted)
  10. Carlo Magni, 2005. "On Decomposing Net Final Values: Eva, Sva and Shadow Project," Theory and Decision, Springer, vol. 59(1), pages 51-95, 08. [Downloadable!] (restricted)
    Other versions:
  11. Thomas Pfeiffer, 2004. "Net Present Value-Consistent Investment Criteria Based on Accruals: A Generalisation of the Residual Income-Identity," Journal of Business Finance & Accounting, Blackwell Publishing, vol. 31(7-8), pages 905-926. [Downloadable!] (restricted)
  12. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
  13. Sunil Dutta, 2002. "Revenue Recognition in a Multiperiod Agency Setting," Journal of Accounting Research, Blackwell Publishing, vol. 40(1), pages 67-83, 03. [Downloadable!] (restricted)
  14. Weingartner, H. Martin, 1966. "The Generalized Rate of Return," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 1(03), pages 1-29, September. [Downloadable!]
  15. Magni, Carlo Alberto, 2000. "Irr, Roe and Npv: Formal and Conceptual Convergences in a Systemic Approach," MPRA Paper 7600, University Library of Munich, Germany. [Downloadable!]
  16. Boadway, Robin & Bruce, Neil, 1984. "A general proposition on the design of a neutral business tax," Journal of Public Economics, Elsevier, vol. 24(2), pages 231-239, July. [Downloadable!] (restricted)
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  17. Magni, Carlo Alberto, 2007. "A Sum&Discount method for appraising firms:An illustrative example," MPRA Paper 6114, University Library of Munich, Germany. [Downloadable!]
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  18. Ignacio Velez-Pareja, 2001. "Economic Value Measurement: Investment Recovery and Value Added - IRVA," MEDICION EVALUACION DEL VALOR 002404, POLITÉCNICO GRANCOLOMBIANO. [Downloadable!]
  19. Magni, Carlo Alberto, 2004. "Modelling excess profit," Economic Modelling, Elsevier, vol. 21(3), pages 595-617, May. [Downloadable!] (restricted)
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  20. Rogerson, William P, 1997. "Intertemporal Cost Allocation and Managerial Investment Incentives: A Theory Explaining the Use of Economic Value Added as a Performance Measure," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 770-95, August.
  21. Gallo, Paolo & Peccati, Lorenzo, 1993. "The appraisal of industrial investments: A new method and a case study," International Journal of Production Economics, Elsevier, vol. 30(1), pages 465-476, July. [Downloadable!] (restricted)
  22. 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. [Downloadable!]
  23. Fernández , Pablo, 2002. "Valuing companies by cash flow discounting: Ten methods and nine theories," IESE Research Papers D/451, IESE Business School. [Downloadable!]
  24. Joseph Tham & Ignacio Velez-Pareja, 2000. "The Correct Discount Rate for the Tax Shield: The N-period Case," MEDICION EVALUACION DEL VALOR 003578, POLITÉCNICO GRANCOLOMBIANO. [Downloadable!]
  25. 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. [Downloadable!] (restricted)
  26. Samuel Weaver & J. Weston, 2003. "A Unifying Theory of Value Based Management," University of California at Los Angeles, Anderson Graduate School of Management 1037, Anderson Graduate School of Management, UCLA. [Downloadable!]
  27. Magni, Carlo Alberto, 2005. "Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I," MPRA Paper 6359, University Library of Munich, Germany, revised 22 Jun 2008. [Downloadable!]
  28. Stoughton, Neal & Zechner, Josef, 2004. "Optimal Capital Allocation Using RAROC(tm) and EVA," CEPR Discussion Papers 4169, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  29. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business, University of Chicago Press, vol. 34, pages 411. [Downloadable!]
  30. Fernandez, Pablo, 2005. "Reply to "Comment on the value of tax shields is NOT equal to the present value of tax shields"," IESE Research Papers D/579, IESE Business School. [Downloadable!]
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  31. Magni, Carlo Alberto, 2003. "Opportunity cost, excess profit and counterfactual conditionals," MPRA Paper 5695, University Library of Munich, Germany. [Downloadable!]
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  32. magni, Carlo Alberto, 2006. "Zelig and the Art of Measuring Excess Profit," MPRA Paper 5663, University Library of Munich, Germany. [Downloadable!]
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  33. Gunther Friedl, 2005. "Incentive Properties of Residual Income When There is an Option to Wait," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 57(1), pages 3–21, January. [Downloadable!]
  34. Magni, Carlo Alberto, 2000. "Systemic Value Added, Residual Income and Decomposition of a Cash Flow Stream," MPRA Paper 5900, University Library of Munich, Germany. [Downloadable!]
  35. Magni, Carlo Alberto, 2000. "Scomposizione di sovraprofitti: Economic Value Added e Valore Aggiunto Sistemico
    [Excess-profit decomposition: Economic Value Added and Systemic Value Added]    ," MPRA Paper 8935, University Library of Munich, Germany. [Downloadable!]
  36. Flavio Pressacco & Patrizia Stucchi, 1997. "Su Una Estensione Bidimensionale del Teorema di Scomposizione di Peccati," Decisions in Economics and Finance, Springer, vol. 20(2), pages 169-185, September. [Downloadable!] (restricted)
  37. Ignacio Velez-Pareja & Joseph Tham, 2003. "Do the RIM (Residual Income Model), EVA® and DCF (Discounted Cash Flow) Really Match?," MEDICION EVALUACION DEL VALOR 002379, POLITÉCNICO GRANCOLOMBIANO. [Downloadable!]
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Ghiselli Ricci, Roberto & Magni, Carlo Alberto, 2009. "Axiomatization of residual income and generation of financial securities," MPRA Paper 14438, University Library of Munich, Germany. [Downloadable!]
  2. Magni, Carlo Alberto, 2005. "On decomposing net final values: EVA, SVA, and shadow project," MPRA Paper 12357, University Library of Munich, Germany. [Downloadable!]
    Other versions:
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