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

Magni, Carlo Alberto (2007): Measuring performance and valuing firms: In search of the lost capital.

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Residual income is an important notion for constructing incentive plans for managers, as well as for valuing firms. In academic papers and in real-life applications this notion is 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 in the firm (or project). The lost-capital paradigm has various interesting economic, financial, 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 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. 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.

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