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Economic profitability and (non)additivity of residual income

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  • Carlo Alberto Magni

    (University of Modena and Reggio
    School of Doctorate E4E (Engineering for Economics—Economics for Engineering))

Abstract

We show that the standard notion of residual income (RI) does not fulfill additive coherence. This gives rise to ambiguities and inconsistencies. The pitfall resides in the capital charge, which blends a non-market value with a market rate. We solve the problem by using a capital charge based on economic return, obtained as the product of a market value and a market rate. The resultant economic RI enjoys additivity. The economic RI is naturally associated to the average Return on Investment (ratio of total income to total invested capital). Subtracting the respective cost of capital (ratio of total economic return to total invested capital) the marginal economic efficiency of the capital is correctly captured. Economic RI guarantees consistency among the various sets of incomes, book values, economic values, accounting rates, and costs of capital, under an investment perspective as well as a financing one, both at a period level and at an aggregate level, either assuming time-invariant or time-varying costs of capital. Therefore, the economic RI offers a coherent tool for the assessment of a project’s or firm’s economic efficiency.

Suggested Citation

  • Carlo Alberto Magni, 2021. "Economic profitability and (non)additivity of residual income," Annals of Finance, Springer, vol. 17(4), pages 471-499, December.
    • Handle: RePEc:kap:annfin:v:17:y:2021:i:4:d:10.1007_s10436-021-00388-2
    DOI: 10.1007/s10436-021-00388-2
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    References listed on IDEAS

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    1. Ian Cooper & Kjell G. Nyborg, 2007. "Valuing the Debt Tax Shield," Journal of Applied Corporate Finance, Morgan Stanley, vol. 19(2), pages 50-59, March.
    2. Magni, Carlo Alberto, 2009. "Splitting up value: A critical review of residual income theories," European Journal of Operational Research, Elsevier, vol. 198(1), pages 1-22, October.
    3. Russell Lundholm & Terry O'Keefe, 2001. "Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model," Contemporary Accounting Research, John Wiley & Sons, vol. 18(2), pages 311-335, June.
    4. Carlo Alberto Magni, 2021. "Internal rates of return and shareholder value creation," The Engineering Economist, Taylor & Francis Journals, vol. 66(4), pages 279-302, December.
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    6. Feenstra, D.W. & Wang, H., 2000. "Economic and accounting rates of return," Research Report 00E42, University of Groningen, Research Institute SOM (Systems, Organisations and Management).
    7. Carlo Alberto Magni, 2020. "Investment Decisions and the Logic of Valuation," Springer Books, Springer, number 978-3-030-27662-1, December.
    8. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411-411.
    9. Carlo Alberto Magni, 2010. "Average internal rate of return and investment decisions: A new perspective," Proyecciones Financieras y Valoración 6653, Master Consultores.
    10. Kay, John A, 1976. "Accountants, Too, Could Be Happy in a Golden Age: The Accountant's Rate of Profit and the Internal Rate of Return," Oxford Economic Papers, Oxford University Press, vol. 28(3), pages 447-460, November.
    11. Diran Bodenhorn, 1964. "A Cash‐Flow Concept Of Profit," Journal of Finance, American Finance Association, vol. 19(1), pages 16-31, March.
    12. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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