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Modelling excess profit

  • Magni, Carlo Alberto

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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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
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30411

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  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
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