Residual Income

6 Key excerpts on "Residual Income"

• 

  eBook - PDF

  Principles of General Management

  The Art and Science of Getting Results Across Organizational Boundaries

  • John L. Colley, Jacqueline L. Doyle, Robert D. Hardie, George W. Logan, Wallace Stettinius(Authors)
  • 2008(Publication Date)
  • Yale University Press

    (Publisher)

  Managers focused on increasing Residual Income at the business unit level will typically make decisions that mirror those of an owner of the com-pany. Residual Income can be measured throughout the organization and align the actions of managers at all levels with the strategic objectives of the company. The Definition of Residual Income Residual Income consists of the “profit” remaining after the sup-pliers of all of the resources that were consumed to generate revenues have been fairly compensated, including the supplier of the capital, the investor or the parent corporation. Residual Income is calculated by assessing a corporate capital charge against the earnings of a profit center, which is subtracted from division income, to arrive at division Residual Income. The capital charge is calculated by multiplying the relevant investment base by a prescribed interest rate that reflects the required return to the 248 CONCEPTS FOR THE GENERAL MANAGER suppliers of capital. Suppose, for example, that a division had a profit of $20,000 per year on an investment (net assets) of $50,000, and the com-pany’s cost of capital was 10 percent. The 10 percent capital charge rate would be applied to the investment base indicating a capital charge of $5,000. The capital charge would then be deducted from the division profit of $20,000 to yield a Residual Income of $15,000. In this example, the return on investment would be 40 percent ($20,000 profit/$50,000 investment). The Residual Income of $15,000 represents profit over and above the cost of the corporate capital investment in the division. The gen-eral manager could use either the 40 percent return on investment (com-pared to the 10 percent cost of capital) or the Residual Income (EVA) of $15,000, or both, as measures of division performance. Some companies also evaluate division performance using the ratio of Residual Income to corporate investment.

  Sign up to read

  Learn more about book
• 

  No longer available |Learn more

  CFA Program Curriculum 2020 Level II, Volumes 1-6 Box Set

  • (Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Introduction Residual Income models of equity value have become widely recognized tools in both investment practice and research. Conceptually, Residual Income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital. The appeal of Residual Income models stems from a shortcoming of traditional accounting. Specifically, although a company’s income statement includes a charge for the cost of debt capital in the form of interest expense, it does not include a charge for the cost of equity capital. A company can have positive net income but may still not be adding value for shareholders if it does not earn more than its cost of equity capital. Residual Income models explicitly recognize the costs of all the capital used in generating income. As an economic concept, Residual Income has a long history, dating back to Alfred Marshall in the late 1800s. 1 As far back as the 1920s, General Motors used the concept in evaluating business segments. 2 More recently, Residual Income has received renewed attention and interest, sometimes under names such as economic profit, abnormal earnings, or economic value added. Although Residual Income concepts have been used in a variety of contexts, including the measurement of internal corporate performance, this reading will focus on the Residual Income model for estimating the intrinsic value of common stock

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  An Entrepreneurial Approach to Stewardship Accountability

  Corporate Residual and Global Poverty

  • Raymond W Y Kao, Kenneth R Kao;Rowland R Kao;;(Authors)
  • 2004(Publication Date)
  • WSPC

    (Publisher)

  Smith gives us the clear idea, however, that there is no income or profit, if capital is encroached upon, and Hicks made it evident that we must consume what we need before there is a residual. Unfortunately, accounting does not clearly provide evidence for capital encroachment, and fails to identify the distribution aspect of net income to contributors of economic undertakings. Even though these may not nec-essarily be supported by professional standards of practice, this does not prevent accounting practitioners from reflecting on how the profession can serve humanity in its innovative and creative efforts. Illuminating note 3: corporate or business residual The accounting bias: In recent years, there has been a great deal of deliberation on the societal aspect of enterprises. However, from the accounting point of view, there has been no clear attempt to recognize contributions made by all other contributors. In fact, only the sharehold-ers contribution is recognized. In summary, the approach is shown in figure 7.2. From figure 7.2, it is clear that the traditional accounting practice has a built-in bias in excluding some classifications. The intrinsic bias reflects capital accumulation in the market economy, but clearly ignores the importance of a fair presentation of information to the public and subse-quently, the distribution of wealth. The adaptation of the residual concept in accounting practice : The Residual Income concept is not new. A simple study of its practice was noted in the Management Control System text of Anthony, Dearden and Vancil. Also, in 1977 James S. Reece and William R. Cool found of the 1,000 largest US industrial firms, 28% had investment centers where consideration for both ROI and “Residual Income” were made.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Guidebook For Supporting Decision Making Under Uncertainties: Today's Managers, Tomorrow's Business

  Today's Managers, Tomorrow's Business

  • Ettore Piccirillo, Massimo Noro(Authors)
  • 2008(Publication Date)
  • World Scientific

    (Publisher)

  2 CRITICAL REVIEW OF ACCOUNTING PERFORMANCE MEASURES Words of caution before you start reading this chapter. This section con-tains a review of accounting performance measures, and represents our long journey to discovering the gaps exposed in current techniques. In essence, this is a summary of our understanding of the current financial measures. It is interesting reading, but do not attempt to finish it all in one go . Residual Income Indicators (RII) are a family of accounting perfor-mance measures defined to be operating profit subtracted with capital charge. A specific Residual Income indicator differs from the other with respect to different definitions of what operating profit and capital charge include. RII are not a new discovery and, indeed Shareholder Value Added (SVA), Economic Value Added (EVA), and Total Business Return (TBR) are just other varieties of Residual Income indicators. Residual Income Indicators The background of Residual Income Indicators (RII) One of the earliest to mention the Residual Income concept was Alfred Marshall in 1890. Marshall defined economic profit as total net gains less the interest on invested capital at the current rate. The idea of residual 19 Guidebook for Supporting Decision-Making Under Uncertainties income appeared first in accounting theory literature early in this century by, e.g. Church in 1917 and by Scovell in 1924, and appeared in management accounting literature in the 1960s. Plenty of Residual Income measures exist as these are created by consult-ing industry and/or by academics. Consultants are forced to use a particular acronym of their concept, although it would not differ very much from the competitors’. Thus, the range of these different acronyms is wide. In the following, we mention only few of them which are relevant to our work and we refer to Makelaines (Makelaines, 1998) for a discussion of few others.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Energy Investments

  An Adaptive Approach to Profiting from Uncertainties

  • Ricardo G. Barcelona(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Residual Income allows valuation metrics to relate to periodic accounting’s monitoring of outcomes. This is made possible by reformulating Eqs. 15.2 and 15.3 as: V p;i ¼ I p;i    1 ð Þ þ l p;i    r ð Þ 1 h i ð15:4Þ Hence, firms will commit to investing when the value accretion is judged suf ficiently consistent with their risk aversion and resource endowments. This satisfies Roy’s (1952) optimality condition, reinforced by Hicks (1964), of achieving returns above a given “disaster level” while minimising losses through loss avoidance and the minimisation of variance. In some cases, Eq. 15.4’s residual returns rate can be specified as a minimum threshold for commitment. Applying our Residual Income approach to our firm, an ACCGT-only supply would conform to the results of Appendix 6. In the discussion that follows, we focus on the economic profits while drawing attention to the implications of basing an investment evaluation on “hybrid” or accounting profits. Economic profitability is a function of cash operating margins, or EBITDA e /Revenue, and asset ef ficiency, or Revenue/Invested Capital. For our firm, we note that: 1. To a large extent, the cost structure is predetermined by the choice of technology. In our case, ACCGT incurs gas as fuel costs, while other variable costs such as labour account for a small proportion of cash operating costs. 2. Asset ef ficiency is partly locked in by the type of technology’s capex, given that revenue is the product of a unified price for power supplied from any source, and the quantity supplied. Hence, what differentiates one supply over another is the initial costs of capex. 3. Assets need to be maintained over their life. To simplify the economic analysis, we impute a notional maintenance capex to recognise the costs of 410 R.G. Barcelona keeping the assets in good operational condition. This is deducted from the cash economic Returns on Invested Capital or RoIC e .

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  International Corporate Governance

  • Kose John, Stephen P. Ferris, Anil K. Makhija, Kose John, Stephen P. Ferris, Anil K. Makhija(Authors)
  • 2015(Publication Date)
  • Emerald Group Publishing Limited

    (Publisher)

  Accounting Review , 86 , 805 824. Bacidore, J., Boquist, J., Milbourn, T., & Thakor, A. (1997). The search for the best financial performance measure. Financial Analysts Journal , 53 , 11 20. Balachandran, S. V. (2006). How does Residual Income affect investment? The role of prior performance measures. Management Science , 52 , 383 394. Baldenius, T., Dutta, S., & Reichelstein, S. (2007). Cost allocation for capital budgeting deci-sions. Accounting Review , 82 , 837 867. Barniv, R., Hope, O.-K., Myring, M. J., & Thomas, W. B. (2009). Do analysts practice what they preach and should investors listen? Effects of recent regulations. Accounting Review , 84 , 1015 1039. Beneish, M. D., Jansen, I. P., Lewis, M. F., & Stuart, N. V. (2008). Diversification to mitigate expropriation in the tobacco industry. Journal of Financial Economics , 89 , 136 157. Bens, D., Berger, P. G., & Monahan, S. J. (2011). Discretionary disclosure in financial report-ing: An examination comparing internal firm data to externally reported segment data. Accounting Review , 86 , 417 449. Berger, P., & Hann, R. (2007). Segment profitability and the proprietary and agency costs of disclosures. The Accounting Review , 82 , 869 906. Berger, P. G., & Ofek, E. (1995). Diversification’s effect on firm value. Journal of Financial Economics , 37 , 39 65. Bernardo, A. E., Luo, J., & Wang, J. J. D. (2006). A theory of socialistic internal capital mar-kets. Journal of Financial Economics , 80 , 485 509. 203 The Role of Residual Income in Divisional Allocation of Funds Berry, T., Bizjak, J. M., Lemmon, M. L., & Naveen, L. (2006). Organizational complexity and CEO labor markets: Evidence from diversified firms. Journal of Corporate Finance , 12 , 797 817. Biddle, G. C., Bowen, R. M., & Wallace, J. S. (1997). Does Eva ® beat earnings? Evidence on associations with stock returns and firm values. Journal of Accounting and Economics , 24 , 301 336. Borghesi, R., Houston, J., & Naranjo, A.

  Sign up to read

  Learn more about book