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Axiomatization of residual income and generation of financial securities

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  • Ghiselli Ricci, Roberto
  • Magni, Carlo Alberto

Abstract

This paper presents an axiomatization of residual income, aka excess profit, and illustrates how it may univocally engenders fixed-income or variable-income assets. In the first part it is shown that, depending on the relations between excess profit and the investor's excess wealth, a well-specified theory of residual income is generated: one is the standard theory, which historically traces back to Hamilton (1777) and Marshall (1890) and is a deep-rooted notion in economic theory, finance, and accounting. Another one is the systemic value added or lost-capital paradigm: introduced in Magni (2000, 2003), the theory is enfolded in Keynes's (1936) notion of user cost and is naturally generated by an arbitrage-theory perspective. In the second part, the paper reverts the usual analysis: instead of computing residual incomes profits from a pattern of cash flows, residual incomes are fixed first to derive vectors of cash flows. It is shown that variable- or fixed-income assets may be constructed on the basis of either theory starting from pre-determined growth rates for excess profit. In particular, zero-coupon bonds and coupon bonds traded in a capital market are shown to be deducted as equilibrium vectors of residual-income-based assets.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 14438.

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Date of creation: 02 Apr 2009
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Handle: RePEc:pra:mprapa:14438

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Keywords: Residual income; excess profit; capital; arbitrage; bond;

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  1. 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.
  2. 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.
  3. Hagemeister, Meike & Kempf, Alexander, 2007. "CAPM und erwartete Renditen: Eine Untersuchung auf Basis der Erwartung von Marktteilnehmern," CFR Working Papers 07-01, University of Cologne, Centre for Financial Research (CFR).
  4. Magni, Carlo Alberto, 2005. "On decomposing net final values: EVA, SVA, and shadow project," MPRA Paper 12357, University Library of Munich, Germany.
  5. 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.
  6. Magni, Carlo Alberto, 2007. "Residual income and value creation: An investigation into the lost-capital paradigm," MPRA Paper 6783, University Library of Munich, Germany.
  7. 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.
  8. Stanley Garstka & William Goetzmann, 1999. "The Development Of Corporate Performance Measures: Benchmarks Before EVA," Yale School of Management Working Papers ysm121, Yale School of Management, revised 01 Jan 2001.
  9. 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.
  10. Stoughton, Neal M. & Zechner, Josef, 2007. "Optimal capital allocation using RAROC(TM) and EVA(R)," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 312-342, July.
  11. Ran Barniv & Mark Myring, 2006. "An International Analysis of Historical and Forecast Earnings in Accounting-Based Valuation Models," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 33(7-8), pages 1087-1109.
  12. Hicks, J. R., 1975. "Value and Capital: An Inquiry into some Fundamental Principles of Economic Theory," OUP Catalogue, Oxford University Press, edition 2, number 9780198282693, September.
  13. Richard P. Brief, 2007. "Accounting Valuation Models: A Short Primer," Abacus, Accounting Foundation, University of Sydney, vol. 43(4), pages 429-437.
  14. 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.
  15. 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.
  16. Peter Sørensen, 1994. "From the global income tax to the dual income tax: Recent tax reforms in the Nordic countries," International Tax and Public Finance, Springer, vol. 1(1), pages 57-79, February.
  17. 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.
  18. Thomas Pfeiffer, 2004. "Net Present Value-Consistent Investment Criteria Based on Accruals: A Generalisation of the Residual Income-Identity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 31(7-8), pages 905-926.
  19. 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.
  20. Roberto Ghiselli Ricci & Carlo Alberto Magni, 2006. "Economic value added and systemic value added: symmetry, additive coherence and differences in performance," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 2(3), pages 151-154, May.
  21. 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.
  22. Ignacio Velez-Pareja, 2001. "Economic Value Measurement: Investment Recovery and Value Added - IRVA," PROYECCIONES FINANCIERAS Y VALORACION 002404, MASTER CONSULTORES.
  23. Carlo Magni, 2005. "On Decomposing Net Final Values: Eva, Sva and Shadow Project," Theory and Decision, Springer, vol. 59(1), pages 51-95, 08.
  24. Paul A. Samuelson, 1964. "Tax Deductibility of Economic Depreciation to Insure Invariant Valuations," Journal of Political Economy, University of Chicago Press, vol. 72, pages 604.
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