Residual Income Defined
What you'll learn
- LOS 21.aCalculate and interpret residual income, economic value added, and market value added.
- LOS 21.bDescribe the uses of residual income models.
Residual income (RI), or economic profit, is the net income of a firm less a charge that measures stockholders’ opportunity cost of capital. The rationale for the residual income approach is that it recognizes the cost of equity capital in the measurement of income. This concept of economic income is not reflected in traditional accounting income, whereby a firm can report positive net income but not meet the return requirements of its equity investors.
Accounting net income includes a cost of debt (i.e., interest expense), but does not reflect dividends or other equity capital related funding costs. This means that accounting income may overstate returns from the perspective of equity investors. Conversely, residual income explicitly deducts all capital costs.
Madeira Fruit Suppliers, Inc., (MFS) distributes fruit to grocery stores in large U.S. cities. The book value of its assets is $1.4 billion, which is financed with $800 million in equity and $600 million in debt. Its before tax cost of debt is 3.33%, and its marginal tax rate is 34%.
MFS has a cost of equity of 12.3%. MFS’s abbreviated income statement is shown in the following figure.
Partial Income Statement for MFS
Determine whether MFS is profitable by calculating residual income and explaining its relationship to reported accounting income.
Solution
While the accounting net income of $80,520,000 indicates that MFS is profitable, it remains to be seen whether the firm is profitable after deducting a charge for equity. The dollar based equity charge is:
Even though MFS is profitable in the traditional accounting sense, it is economically unprofitable after taking into account the necessary charge to meet stockholders’ opportunity cost of supplying capital to the company.
EVA and MVA
Economic value added () measures the value added for shareholders by management during a given year. EVA is calculated as:
The analyst should make the following adjustments (if applicable) to the financial statements before calculating NOPAT and invested capital:
- Capitalize and amortize research and development charges (rather than expense them), and add them back to earnings to calculate NOPAT.
- Add back charges on strategic investments that will generate returns in the future.
- Eliminate deferred taxes and consider only cash taxes as an expense.
- Treat operating leases as capital leases and adjust nonrecurring items.
- Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT.
Market value added (MVA) is the difference between the market value of a firm’s long term debt and equity and the book value of invested capital supplied by investors. It measures the value created by management’s decisions since the firm’s inception. MVA is calculated as:
VBM, Inc., reports NOPAT of $2,100, a WACC of 14.2%, and invested capital of $18,000 at the beginning of the year and $21,000 at the end of the year. The market price (year end) of the firm’s stock is $25 per share, and VBM has 800 shares outstanding. The market value (year end) of the firm’s long term debt is $4,000. Calculate VBM’s EVA and MVA.
Solution
First calculate EVA:
The market value of the company is the market value of the equity plus the market value of the debt:
The firm’s MVA is:
There are several commercially available residual income based valuation models. It is interesting to note that these models, like EVA and MVA, usually apply the concept of residual income to the measurement of managerial effectiveness and executive compensation. However, for the exam we’re most interested in the equity valuation applications of residual income models.
Residual income models have also been proposed as a method to measure goodwill impairment.