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A positive RI indicates that value has been created for shareholders. A negative RI means valued destruction for shareholders. It measures the economic rather than accounting profit by a business after the cost of all financial resources has been taken into account.
Financial Statements are prepared to reflect earnings available to owners but not whether this earnings sufficient to meet their expectations. Traditional accounting doesnt show whether shareholder has earned what they expected, and leaves to the owners the determination as to whether the earnings are sufficient to meet their cost of equity. An economic concept to whether the cost of equity capital is needed. Residual Incomes provides information regarding the incremental value created by a firm or project. Note that it could also be a reduction in value in which case wealth is destroyed.
Residual Income
Remember that objective is to maximize shareholderwealth. This can be achieved by maximizing Residual Income, and not maximizing return on investment (ROI). WHY? Because if a manager is evaluated based on ROI will reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimum rate of return for the entire company.
Any project whose rate of return is above the minimum required rate of return of the company will result in an increase in residual income.
EBIT Less: Interest Expense Pre-Tax Income Income Tax Expense Net Income What is its residual income?
Expected Equity Return = Equity Cost of Equity = 1,000,000 12% = 120,000 Net Income Expected Equity Return Residual Income 91,000 120,000 (29,000)
AMC did not earn enough to cover the cost of equity. As a result, it has negative residual income.
Residual income has also been called economic profit and economic value added since it represents the economic profit of the firm after deducting the cost of all financial resources, debt and equity. The term abnormal earnings is also used. Assuming that over the long term the firm is expected to earn its cost of capital (from all sources), any earnings in excess of the cost of capital can be termed abnormal earnings. Economic Value Added is computed as: NOPAT WACC (D+E)
NOPAT: Net Operating Profit After Taxes, WACC: Weighted Average Cost of Capital D: Debt E: Equity.
B0 Bt RIt r Et
=Book value of equity at the beginning, =Book value of equity at time t, = Et rBt-1 = Residual income in future periods, = Required rate of return on equity, = Net Income during period t,
Perpetuity example
1) Since the dividend is a perpetuity, P0 = D / r = 1.00 / 0.10 = $10.00 per share. 2) The net income is $1.00 each year, the book value is always $6.00, and the required return is 10%, so the residual income in every year will be:
The relationship between earnings, dividends and book value is given by:
Bt Bt 1 Et Dt
Derivation of RIM
Then, Dt = Et (Bt Bt-1) = Et + Bt-1 Bt
This equation is logically equivalent to the one above since: RIt = (ROEt r)Bt-1. Note that other than the required rate of return, the inputs to the residual income model are based upon accounting data.
Note: since the residual incomes for each year are necessarily the same in questions 1 & 2, the results for stock valuation are identical.
ROE t r P0 B0 B0 rg
B0 reflects the value of assets owned by the firm less its liabilities. B0(ROE-r)/(r-g), represents additional value that is expected due to the firms ability to generate returns in excess of its cost of equity. It represents the value of the firms economic profits. If a firm earns exactly the cost of equity the price should equal the book value per share.
Residual income models, dividend discount models, and free cash flow models are all theoretically sound.
DDM and FCFE models forecast future cash flows and find the value of stock by discounting them back to the present using the required return on equity.
RI model approaches this process differently. It starts with the book value of equity, and then makes adjustments to this value by adding the present values of future residual income (which can be positive or negative). The recognition of value is different, but the total present value of these values (whether future dividends, future free cash flow, or book value plus future residual income) should be logically consistent.