Residual Income and Value Creation: An Investigation into the Lost-Capital Paradigm

European Journal of Operational Research, Vol. 201, No. 2, pp. 505-519, 2010

34 Pages Posted: 16 Nov 2007 Last revised: 29 Nov 2009

See all articles by Carlo Alberto Magni

Carlo Alberto Magni

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering)

Date Written: November 13, 2007

Abstract

This paper presents a new way of measuring residual income, originally introduced by Magni (2000a,b,c, 2001a,b, 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 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 an aggregation property. 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; Young and O'Byrne's (2001) Adjusted EVA; Keynes's (1936) user cost; Drukarczyk and Schueler's (2000) Net Economic Income; Fernandez'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, capital budgeting decision-making, managerial incentives and control.

Keywords: Management accounting, corporate finance, residual income, value creation, incentive compensation, outstanding

JEL Classification: D40, D46, G11, G12, G30, G31, M21, M40, M41, M52

Suggested Citation

Magni, Carlo Alberto, Residual Income and Value Creation: An Investigation into the Lost-Capital Paradigm (November 13, 2007). European Journal of Operational Research, Vol. 201, No. 2, pp. 505-519, 2010, Available at SSRN: https://ssrn.com/abstract=1029680

Carlo Alberto Magni (Contact Author)

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering) ( email )

Italy

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