Hankamer School of Business Working Paper
30 Pages Posted: 22 Jul 2003
Date Written: May 28, 2003
This paper reviews the theoretical foundations of residual income as a tool for evaluating a firm's interim performance for purposes of assigning incentive compensation. Although residual income can be easily linked to the discounted cash flow model of firm valuation, it bears no necessary relation to wealth creation during any particular time period. Consequently, paying for performance using residual income to measure wealth creation can have incentive effects that are inconsistent with wealth creation. We show that recent attempts to address the shortcomings of residual income can effectively address the wealth measurement issue; however, they give rise to serious implementation problems related to the necessity for forecasting future firm performance. Furthermore, if internal forecasts of future firm performance are used, this is a source of a potentially serious moral hazard problem as the same managers whose performance is being evaluated provide the forecasts.
Keywords: Residual income, Economic Value Added, Performance measurement, Incentive compensation
JEL Classification: G31, G34, J33, M41, M46
Suggested Citation: Suggested Citation
Martin, John D. and Petty, J. William and Rich, Steve, An Analysis of EVA and Other Measures of Firm Performance Based on Residual Income (May 28, 2003). Hankamer School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=412122 or http://dx.doi.org/10.2139/ssrn.412122