Residual Income

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JUSTUS-LIEBIGUNIVERSITÄT
GIESSEN

Andreas Bausch / Barbara E. Weißenberger / Marcus Blome

Is market value-based residual income a superior
performance measure compared to book value-based
residual income?
Working Paper 1 / 2003

– Arbeitspapiere Industrielles Management und Controlling – Herausgeber:

Professur für Betriebswirtschaftslehre mit dem Schwerpunkt Industrielles Management und Controlling (Prof. Dr. Barbara E. Weißenberger) Justus-Liebig-Universität, Gießen
http://wiwi.uni-giessen.de/controlling/

JEL-Classification:

M40

Vortrag auf dem Kongress der European Accounting Association am 04.04.2003, in Sevilla, Spanien

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Is market value-based residual income a superior performance measure compared to book value-based residual income?

Abstract
With the increasing use of residual income-based concepts of performance measurement, significantly different formulas are proposed for calculating both the firm’s operating profit as well as its cost of capital. On the one hand, there is the traditional book value-based approach (EVA), on the other hand there are market value-based approaches, in which either only the cost of capital (REVA) or both cost of capital and the firm’s operating profit before interest (residual economic income, REI) are determined by using market values. In our paper, we compare the advantages and disadvantages of these different types of residual income measurement. Our results are the following. First, we show that REVA compared to EVA might lead to underinvestment in projects with a strictly positive net present value as well as to overinvestment in projects with a strictly negative net present value even if principal and agent discount a project’s income stream at the same rate. Second, we show that a proposition to base incentives on strictly positive EVA targets derived from an observed Market Value Added (MVA) equals the application of a REVA-type performance measure and, therefore, might be afflicted with the same deficiencies. Keywords: Residual Income Measurement, Economic Value Added, Refined Economic Value Added, Economic Income, Incentives

Acknowledgements:
We would like to thank participants at the 2003 EAA conference in Sevilla (Spain) for helpful comments and discussion. We gratefully acknowledge financial support of KPMG Deutsche Treuhand Gesellschaft mbH and of the Schmalenbach-Gesellschaft für Betriebswirtschaft e.V.

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Introduction

In recent years, different concepts of residual income measurement have been widely discussed within the field of value-based management in both academic research and corporate practice. The objective has been to define a performance measure that strictly motivates an agent to implement all available investment projects with a non-negative net present value. Typical assumptions under which these types of performance measurement are discussed are the existence of unrestricted financial means at a given cost of capital and information asymmetry between the principal and the agent with regard to the net present value of the investment projects chosen by the agent. Generally, residual income is measured by deducting a capital charge from the firm’s profit. The exact way on how either profit or cost of capital is measured, is not specified at all. The only crucial assumption made in most cases is that the sum of accrued earnings measuring the firm’s operating profit equals the sum of cash flows from operating and financing activities. In that case, Preinreich (1937) and Lücke (1955) have shown that the sum of discounted residual income resulting from a given investment project is equal to the project’s net present value. Consequently, residual income measurement leads to an equivalent project choice compared to decision-making based on a project cash flows: the value of the discounted residual income stream equals the project’s net present value.

Among the many concepts of residual income measurement that...
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