Axiomatization of Residual Income and Generation of Financial Securities

Abstract:     
This paper presents an axiomatization of residual income, aka excess profit, and illustrates how it may univocally engenders fixed-income or variable-income assets. In the first part it is shown that, depending on the relations between excess profit and the investor's excess wealth, a well-specified theory of residual income is generated: one is the standard theory, which historically traces back to Hamilton (1777) and Marshall (1890) and is a deep-rooted notion in economic theory, finance, and accounting. Another one is the systemic value added or lost-capital paradigm: introduced in Magni (2000, 2003), the theory is enfolded in Keynes's (1936) notion of user cost and is naturally generated by an arbitrage-theory perspective. In the second part, the paper reverts the usual analysis: instead of computing residual incomes profits from a pattern of cash flows, residual incomes are fixed first to derive vectors of cash flows. It is shown that variable- or fixed-income assets may be constructed on the basis of either theory starting from pre-determined growth rates for excess profit. In particular, zero-coupon bonds and coupon bonds traded in a capital market are shown to be deducted as equilibrium vectors of residual-income-based assets.

Number of Pages in PDF File: 35

Keywords: Residual income, excess profit, capital, arbitrage, bond

JEL Classification: C00, C60, D53, G00, G12, G31, M21, M41

Accepted Paper Series