The Link Between Residual Income and Value Created for Levered Firms: A Note
Posted: 21 Feb 2008
In addition to other contributions to the literature, this note shows how value created can be measured if firms are financed not only by equity, but also by debt. We deal with this capital structure using the weighted average cost of capital (WACC) approach. We show that measuring value creation with residual incomes requires the use of a modified WACC for levered firms. Thus, we caution against applying the standard definition of WACC carelessly. This insight is important for all applications in which information about the performance of past periods is needed as for post-acquisition audits, capital budgeting or bonus banks.
Keywords: residual income, WACC, value-based management, performance measurement
JEL Classification: M40, M41, M46, G12, G31, G32
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