Residual income and value creation: An investigation into the lost-capital paradigm

Magni, Carlo Alberto (2007): Residual income and value creation: An investigation into the lost-capital paradigm.

Abstract

This paper presents a new way of measuring residual income, originally introduced by Magni (2000a, 2000b, 2003). Contrary to the standard residual income, the capital charge is equal to the capital lost by investors. The lost capital may be viewed as (a) the foregone capital, (b) the capital implicitly infused into the business, (c) the outstanding capital of a shadow project, (d) the claimholders' credit. Relations of the lost capital with book values and market values are studied, as well as relations of the lost-capital residual income with the classical standard paradigm; many appealing properties are derived, among which a property of earnings aggregation. Different concepts and results, provided by different authors in such different fields as economic theory, management accounting and corporate finance, are considered: O'Hanlon and Peasnell's (2002) unrecovered capital and Excess Value Created; Ohlson's (2005) Abnormal Earnings Growth; O'Byrne's (1997) EVA improvement; Miller and Modigliani's (1961) investment opportunities approach to valuation; Keynes's (1936) user cost; Drukarczyk and Schueler's (2000) Net Economic Income, Fernandez's (2002) Created Shareholder Value, Anthony's (1975) profit. They are all conveniently reinterpreted within the theoretical domain of the lost-capital paradigm and conjoined in a unified view. The results found make this new theoretical approach a good candidate for firm valuation, incentive compensation, capital budgeting decision-making

• Item Type: MPRA Paper
• Language: English
• Keywords: Corporate finance, management accounting, valuation, residual income, value creation, incentive compensation, outstanding capital, lost capital, net present value, book value, market value
• Subjects: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; D - Microeconomics > D4 - Market Structure, Pricing, and Design > D40 - General; 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; D - Microeconomics > D4 - Market Structure, Pricing, and Design > D46 - Value Theory; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M41 - Accounting; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G0 - General; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M2 - Business Economics > M21 - Business Economics

References

Anthony, R.N. (1975). Accounting for the Cost of Interest. Lexington, MA: D.C. Heath and Company.

Arnold, G. 2005. Corporate Financial Management. Harlow, UK: Pearson Education.

Arnold, G. and M. Davies (Eds.) (2000). Value-based Management: Context and Application. Chichester, UK: John Wiley & Sons.

Bodenhorn, D. (1959). On the problem of capital budgeting, Journal of Finance, 14(4), 473-492.

Brief, R.P. and R.A. Lawson 1990. The role of the accounting rate of return in financial statement analysis. The Accounting Review. Reprinted in R. Brief & K. V. Peasnell (Eds.), A Link Between Accounting and Finance. New York: Garland, 1996.

Brief, R.P. and K.V. Peasnell (Eds.) 1996. Clean Surplus: A Link Between Accounting and Finance. New York and London: Garland Publishing.

Buchanan, J. (1969). Cost and Choice. An Inquiry in Economic Theory. Chicago: Markham. Republished as Midway reprint, Chicago: University of Chicago Press, 1977.

Coase, R.H. (1968). The nature of costs. In D. Solomons (ed.), Studies in Cost Analysis, London: Sweet & Maxwell, second edition.

DeAngelo, H. and L. DeAngelo (2006). The irrelevance of the MM dividend irrelevance theorem. Journal of Financial Economics, 79, 293-315.

Drukarczyk, J. and A. Schueler (2000). Approaches to value-based performance measurement. In G. Arnold & M. Davies (Eds.), Value-based Management: Context and Application. Chichester, UK: John Wiley & Sons

Edwards, E. and P. Bell (1961). The Theory and Measurement of Business Income. Berkeley: University of California Press.

Ehrbar, A. (1998). Eva: The Real Key to Creating Value. New York: John Wiley & Sons.

Fernandez, P. (2002). Valuation Methods and Shareholder Value Creation. San Diego, CA: Elsevier Science.

Forker, J. and R. Powell (2000). A review of accounting and VBM alternatives. In G. Arnold and M. Davies, Value-based Management: Context and Application. Chichester, UK: John Wiley & Sons.

Ghiselli Ricci, R. and C.A. Magni (2006). Economic Value Added and Systemic Value Added: Symmetry, additive coherence and differences in performance. Applied Financial Economics Letters, 2(3), 151-154, May.

Grinyer, J.R. (1985). Earned Economic Income. A theory of matching. Abacus, 21(2), 130-148.

Grinyer, J.R. (1987). A new approach to depreciation. Abacus, 23(2), 43-54.

Grinyer, J.R. (1995). Analytical Properties of Earned Economic Income { a response and exten sion. British Accounting Review, 27, 211-228.

Kellison, S.G. (1991). The Theory of Interest, second edition. Homewood, IL: Irwin/McGraw Hill.

Keynes, J.M. (1967). The General Theory of Employment Interest and Money. London: MacMillan. First published 1936.

Lundholm, R. and T. O'Keefe (2001). Reconciling value estimates from the discounted cash flow model and the residual income model. Contemporary Accounting Research 18(2) 311-335, Summer.

Magni, C.A. (2000a). Systemic Value Added, residual income and decomposition of a cash flow stream. Working paper n. 318, Department of Economics Economy, University of Modena and Reggio Emilia. Available at <http://merlino.unimo.it/web dep/materiali discussione/0318.pdf>

Magni, C.A. (2000b). Decomposition of a certain cash flow stream: differential systemic value and net final value, Proceedings of the XXIV Conference of AMASES (Association for the Mathematics Applied to Economic and Social Sciences), Padenghe, Italy.

Magni, C.A. (2003). Decomposition of net final values: Systemic Value Added and residual income, Bulletin of Economic Research 55(2), 149-176.

Magni, C.A. (2004). Modelling excess profit, Economic Modelling, 21, 595-617.

Magni, C.A. (2005). On decomposing net final values: EVA, SVA and shadow project. Theory and Decision. 59, 51-95.

Magni, C.A. (2006). Zelig and the art of measuring excess profit, Frontiers in Finance and Economics, 3(1), 103-129, June.

Magni, C.A. (2007). Relevance or irrelevance of retention for dividend policy irrelevance. Available at SSRN: <http://ssrn.com/abstract=1027401>.

Magni, C.A. (forthcoming). Opportunity cost, excess profit, and counterfactual conditionals, Frontiers in Finance and Economics. Available at SSRN: <http://ssrn.com/abstract=1028749>.

Martin, J.D. and J.W. Petty (2000). Value Based Management. The Corporate Response to Shareholder Revolution. Boston, MA: Harvard Business School.

Martin, J.D., J.W. Petty and S.P. Rich (2003). An analysis of EVA and other measures of firm performance based on residual income. Hankamer school of Business Working paper. Available at SSRN: <http://papers.ssrn.com/sol3/papers.cfm?abstract id=412122>.

Miller, M. and F. Modigliani (1961). Dividend policy, growth, and the valuation of shares. Journal of Business, 34, 411-433.

O'Byrne. S.F. (1996). EVA and market value. Journal of Applied Corporate Finance, 9(1), 116-125, Spring.

O'Byrne. S.F. (1997). EVA and shareholder return. Financial Practice and Education, 7(1), Spring/Summer.

O'Byrne. S.F. and D.S. Young (2006). Incentives and investor expectations. Journal of Applied Corporate Finance, 18(2) 98-105, Spring.

O'Hanlon, J. and K.V. Peasnell (2000). Residual income and EVA. Economic and Financial Computing, Summer, 53-95.

O'Hanlon J. and K.V. Peasnell (2002). Residual income and value creation: the `missing link', Review of Accounting Studies, 7(2/3), 229-245.

Ohlson, J.A. (1989). Accounting earnings, book values, and dividends: The theory of the clean surplus equation in equity valuation. Reprinted in R. Brief & K. V. Peasnell (Eds.), A Link Between Accounting and Finance. New York: Garland, 1996, 167-227.

Ohlson. J.A. (1995). Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research 11(2) 661-687, Spring.

Peasnell, K.V. (1981). On capital budgeting and income measurement. Abacus, 17(1), 52-67, June.

Peasnell, K.V. (1982). Some formal connections between economic values and yields and accounting numbers. Journal of Business Finance & Accounting, 9(3), 361-381.

Peasnell, K.V. (1995). Second thoughts on the analytical properties of earned economic income. British Accounting Review, 27, 229-239.

Peccati, L. (1992). Multiperiod analysis of a levered portfolio. In: J. Spronk & B. Matarazzo (Eds.) Modelling for Financial Decisions. Berlin: Springer-Verlag.

Penman, S.H. 1992. Return to fundamentals. Journal of Accounting Auditing and Finance Reprinted in R. Brief and K. V. Peasnell (Eds.) (1996). Clean Surplus: A Link Between Accounting and Finance. New York and London: Garland Publishing.

Preinreich, G. 1936. The fair value and yield of common stock. The Accounting Review Reprinted in R. Brief and K. V. Peasnell (Eds.) (1996). Clean Surplus: A Link Between Accounting and Finance. New York and London: Garland Publishing.

Preinreich, G. (1938). Annual survey of economic theory: the theory of depreciation. Econometrica 6(1), 219-241, January.

Promislow, S.D. (2006). Fundamentals of Actuarial Mathematics. Chichester, UK: John Wiley & Sons.

Rappaport, A. (1998). Creating Shareholder Value. New York: The Free Press.

Robichek, A.A. and S.C. Myers (1965). Optimal Financing Decisions. Englewood Cliffs, NJ: Prentice-Hall.

Ruback, R.S. (2002). Capital Cash Flows: a simple approach to valuing cash flows. Financial Management, Summer, 85-103.

Scott, A.D. (1953). Notes on user cost. Economic Journal, 63, 368-384, June.

Solomons, D. (1965). Divisional Performance: Measurement and Control. Homewood, IL: Richard D. Irwin. Soper, C.S. (1959). The marginal efficiency of capital. Economic Journal, 69, 174-177 March.

Stewart, G.B. (1991). The Quest for Value: the EVATM Management Guide. HarperCollins Publishers Inc.

Teichroew, D., A. Robichek, and M. Montalbano (1965a). Mathematical analysis of rates of return under certainty. Management Science, 11, 395-403.

Teichroew, D., A. Robichek, and M. Montalbano (1965b). An analysis of criteria for investment and financing decisions under certainty. Management Science, 12, 151-179. Vélez-Pareja, I. and J. Tham (2003). Do the RIM (Residual Income Model), EVA and DCF (Discounted Cash Flow) really match?. Working Paper n. 25. <http://ssrn.com/abstract=379740.>

Walter, J.E. (1956). Dividend policies and common stock prices. Journal of Finance, 11(1), 29-41.

Weaver S.C. and J.F. Weston (2003). A unifying theory of value based management. Finance. Paper 4-03. Available at <http://repositories.cdlib.org/anderson/n/4-03/>

Young, S.D. and S.F. O'Byrne (2001). EVA and Value-Based Management. McGraw-Hill.