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 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Corporate finance, management accounting, residual income, performance measurement, lost capital, value-based management, firm valuation, abnormal earnings aggregation
• 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

References

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

Brealey, R. A., S. C. Myers 2000. Principles of Corporate Finance, Irwin McGraw-Hill.

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

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

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

Copeland, T., T. Koller, J. Murrin 2000. Valuation. Measuring and Managing the Value of Companies. New York: John Wiley & Sons.

Edwards, E., 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.

Feltham, G. A., J. A. Ohlson 1995. Valuation and clean surplus accounting for operating and nancial activities, Cont. Acc. Res. 11, 689-731.

Fernández, P. 2002. Valuation Methods and Shareholder Value Creation. Elsevier Science, San Diego, CA.

Fernández, P. 2005. Reply to "Comment on The value of Tax Shields is NOT equal to the present value of tax shields". Quart. Rev. of Ec. and Fin. 45(1) 188-192.

Franks, J. R., S. D. Hodges 1984. The meaning of accounting numbers in target setting and performance measure- ment: implications for managers and regulators. In R. Brief and K. V. Peasnell (Eds.) (1996). Clean Surplus: A Link Between Accounting and Finance. New York and London: Garland Publishing.

Grinblatt, M., S. Titman 2002. Financial Management and Corporate Strategy, second edition. Boston, MA: Irwin/McGraw-Hill.

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 extension British Acc. Rev., 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.

Lee, T. 1985. Income and Value Measurement. Theory and Practice, third edition. Billing & Sons, Worcester, UK.

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

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

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

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

Martin, J. D., J. W. Petty 2000. Value Based Management. Boston, MA: Harvard Business School Press

Martin, J. D., J. W. Petty, S. Rich 2003. An Analysis of EVA and Other Measures of Firm Performance Based on Residual Income, Working paper, <http://ssrn.com/abstract=412122>.

Myers, S. C. 1974. Interactions of corporate nancing and investment decisions - Implications for capital budgeting. J. of Fin., 29(1) 1-25, March.

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

O'Hanlon, J., K. V. Peasnell 2000. Residual income and EVA. Ec. and Fin. Computing, Summer, 53-95.

O'Hanlon J., K. V. Peasnell 2002. Residual income and value creation: the `missing link', Rev. of Acc. 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. Unpublished paper, Columbia University. Reprinted in R. Brief & K. V. Peasnell (Eds.), A Link Between Accounting and Finance. New York: Garland, 1996.

Ohlson. J. A. 1995. Earnings, book values, and dividends in equity valuation. Contemp. Acc. Res. 11(2) 661-687, Spring.

Palepu, K. G., P. M. Healey, V. L. Bernard (2000). Business Analysis and Valuation Using Financial Statements. Cincinnati: South-Western College Publishing.

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

Peasnell, K. V. 1982. Some formal connnections between economic values and yields and accounting numbers. J. of Bus. Fin. Acc. 9(3) 361-381.

Peasnell, K. V. 1995. Second thoughts on the analytical properties of earned economic income. British Acc. Rev., 27, 229-239.

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

Penman, S. H. 1992. Return to fundamentals. J. of Acc. Audit. and Fin. 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 Acc. Rev. 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.

Revsine, L., D. W. Collins, W. B. Johnson 2005. Financial Reporting and Analysis, third edition. Upper Saddle River, NJ: Pearson Prentice Hall.

Ruback, R. S. 2002. Capital Cash Flows: a simple approach to valuing cash flows. Fin. Manag., Summer, 85-103.

Scott, A. D. 1953. Note on user cost. Ec. J., 63, 368-384, June.

Solomons, D. 1965. Divisional Performance: Measurement and Control. Homewood, IL: Richard D. Irwin.

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

Vélez-Pareja, I., 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>.

Weaver S. C., J. F. Weston 2005. A unifying theory of value based management. Working paper, <http://repositories.cdlib.org/anderson/fin/4-03/>.

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