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# Performance Measurement by Residual Income Method

In ACCA Advanced Performance Management (APM), residual income is one of performance measure in strategic performance measurement. You are required to understand the application of this measure.

By word residual means whatever is left of, so residual income would imply to be whatever is left for after deducting all expenses. Theoretically, the residual income is business performance or evaluation measure in terms of equity return.

Shareholders invest money in a business and expect return against it, as they bear all the risk for their money. Many other measures can be used in performance or total equity evaluations such as dividend discount model, ROCE, ROI, or EVA, etc. Residual income stresses on economic value added more than measuring net profits.

## Residual Income Definition and Formula

Residual income can be defined in many ways; essentially it is the net income minus the charge for net assets employed in the business. The net assets of the business are what shareholders’ are left with. The term can also be dubbed as an equity charge.

In net profit calculations, the cost of capital or debt cost includes the interest charged. The Residual income (RI) model incorporates a similar charge for equity employed in the business.

Residual Income can be calculated as:

Residual Income (RI) = Net profits – Equity Charge

Equity Charge = Total Equity × Cost of Equity Capital

The equity charge is deducted to evaluate the true value of profits generated by the business for the equity holders i.e. shareholders. It is considered the compensation for shareholders as an opportunity cost that shareholders bear for investing money in the business. The notion behind evaluating company performance with a Residual Income is that net profits may not be good enough compensation for risky investments that Shareholders take on.

In that way, a business may be generating positive cash flows and surplus net profits, but with Residual income may still not be positive. The effects of residual income expectations and the difference between net profits and residual income can be explained with the help of a simple example.

Suppose Aramex co. has the following abstract from their Income Statement: For residual income calculations:

Capital (Equity plus long-term debt) = \$ 70,000

Cost of equity = 13%

So Equity Charge = \$ 70,000 × 13% = \$ 9,100

The equity charge of \$9,100 represents the minimum return required by the providers of finance on the \$70,000 capital they provided. Since the actual profit of the division exceeds this, the division has recorded residual income of \$900.

## Brief History of Residual Income Method

The first use of the residual income method dates back to the 1800s when Alfred Marshal introduced the concept in his book “Some Fundamental Notion”. In recent history, the researchers Liu et al. (2002), Feltham and Ohlson (1995), Ohlson (1995), and Penman (1997, 2001) have argued for the residual income method by comparing it closely with the discounted cash flow method.

The modernized and a similar approach to the residual income model is the economic value added (EVA) model. That builds closely on the RI basis with a slight variation of using net profit after tax and using total cost charge. It uses total cost and WACC to calculate the total cost charge instead of the equity charge used in the residual income method.

## Residual Income Interpretation as a Performance Measure

If we can embed the equity charge into the income statement and calculate the residual income for one accounting period, it can be used to evaluate the stocks for any number of years too. This approach is very similar to the dividend discount model, or NPV calculations with DCFs when evaluating the future stock or project performances.

For business valuation in terms of Residual Income, the current book value of the stocks and future income (RI) is calculated in terms of present value. The fair value of the business can be calculated as: The RI model takes into account the current book value of the stocks and adds the present value of future residual income with the stock.

## WORKING EXAMPLE

Suppose Beta Co. expects the EPS for the company for the next three years as \$2.00, \$ 2.50, and \$ 4.00. The current Share price is given at \$ 47. The Book value of the share is \$ 6.00 with an expected rate of equity at 7%. Expected dividends for the next three years are \$ 1.00, \$ 1.25, and \$ 5.30.

Using the residual income formula, we can calculate the residual income for the next three years and the value of the stocks in the present value term. And RI = Net profits – Equity Charge, and

Equity Charge = Total Equity × Cost of Equity Capital So the Value of Stock can be calculated as: ## Residual Income Uses in Practice

The residual income method can be used in practice for performance evaluation similar to the DDM or DCF methods. As it incorporates the equity charge at the expected rate of return of shareholders, it can be used to evaluate the value of the business. A project proposal with cash flows expected in the future can also be discounted in present value terms, provided the cost of equity for the project is known or calculable.

In corporate finance, the top management may also consider the residual income method to evaluate project specific or divisional performances based on equity rate of return charged Residual income. As this approach subtracts the equity charge from the net profits after tax, it may offer a reasonable insight into the actual performance of the project or a division within a business.

## Advantages of the Residual Income Method

The residual income method can be used in both performance appraisals of a project, division, and business valuations. It considers the future cash flows in the present value term, which is the most liked approach in investment appraisals.

Its benefits closely resemble those arising from the dividend discount model or discounted cash flow models in present value terms. Some benefits of the Residual Income method in performance appraisals and business valuations include:

• It focuses on the economic profits of the business rather tha