Economic Profitability and (Non)Additivity of Residual Income

Annals of Finance 2021, 17, 471–499. https://doi.org/10.1007/s10436-021-00388-2

30 Pages Posted: 28 May 2021 Last revised: 13 Jan 2022

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: May 27, 2021

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.

Keywords: Accounting and finance, residual income, economic value, net present value, non- additivity, inconsistencies

JEL Classification: G30, G31, G10, G11, M41

Suggested Citation

Magni, Carlo Alberto, Economic Profitability and (Non)Additivity of Residual Income (May 27, 2021). Annals of Finance 2021, 17, 471–499. https://doi.org/10.1007/s10436-021-00388-2, Available at SSRN: https://ssrn.com/abstract=3854965

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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
14
Abstract Views
172
PlumX Metrics