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.

Abstract

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Performance measurement, value-based management, residual income, incentive compensation, lost capital, Economic Value Added, firm value
• Subjects: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M41 - Accounting; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M5 - Personnel Economics > M52 - Compensation and Compensation Methods and Their Effects; G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M40 - General

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