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Measuring performance and valuing firms: In search of the lost capital

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  • Magni, Carlo Alberto

Abstract

Residual income as commonly described in academic papers and in real-life applications may be formally described as a function of three variables: (i) the capital invested, (ii) the rate of return, (iii) the opportunity cost of capital. This paper shows that a different paradigm of residual income is generated if a fourth element is added: (iv) the capital that investors lose if they infuse their funds into the firm (or project). The lost-capital paradigm has various interesting economic, nancial, accounting interpretations and bears intriguing formal and conceptual relations to the standard paradigm. It may be soundly employed in real-life applications as a tool for rewarding managers as well as for appraising firms. Firm value is shown to be a function of total abnormal earnings and independent of time, if the new paradigm is used: what matters is only the book value and the sum of total expected residual incomes, not the periods in which they are generated. This aggregation property is particular important for highlighting the link between accounting values and market values. A numerical example illustrates the practical implementation of the new paradigm to the Economic Value Added and the Edwards-Bell-Ohlson model; also, a model is presented which has the nice property of being aligned in sign with the Net Present Value: this makes it a good candidate for use in value-based management.

Suggested Citation

  • Magni, Carlo Alberto, 2007. "Measuring performance and valuing firms: In search of the lost capital," MPRA Paper 5850, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:5850
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    References listed on IDEAS

    as
    1. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
    2. Myers, Stewart C, 1974. "Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting," Journal of Finance, American Finance Association, vol. 29(1), pages 1-25, March.
    3. 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.
    4. Magni, Carlo Alberto, 2000. "Systemic Value Added, Residual Income and Decomposition of a Cash Flow Stream," MPRA Paper 5900, 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, April.
    6. 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. 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.
    2. 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".

    More about this item

    Keywords

    Corporate finance; management accounting; residual income; performance measurement; lost capital; value-based management; firm valuation; abnormal earnings aggregation;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General

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