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, 2000c, 2001a, 2001b, 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 \emph{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, Fern\'{a}ndez'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, residual income, market value, outstanding capital, lost capital, net present value, book 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

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