Measuring performance and valuing firms: In search of the lost capital

Carlo Alberto Magni

MPRA Paper from University Library of Munich, Germany

Abstract: Residual income as commonly described in academic papers and in real-life applications may be formally described as a function of three variables: (i) the capital invested, (ii) the rate of return, (iii) the opportunity cost of capital. This paper shows that a different paradigm of residual income is generated if a fourth element is added: (iv) the capital that investors lose if they infuse their funds into the firm (or project). The lost-capital paradigm has various interesting economic, nancial, accounting interpretations and bears intriguing formal and conceptual relations to the standard paradigm. It may be soundly employed in real-life applications as a tool for rewarding managers as well as for appraising firms. Firm value is shown to be a function of total abnormal earnings and independent of time, if the new paradigm is used: what matters is only the book value and the sum of total expected residual incomes, not the periods in which they are generated. This aggregation property is particular important for highlighting the link between accounting values and market values. A numerical example illustrates the practical implementation of the new paradigm to the Economic Value Added and the Edwards-Bell-Ohlson model; also, a model is presented which has the nice property of being aligned in sign with the Net Present Value: this makes it a good candidate for use in value-based management.

Keywords: Corporate finance; management accounting; residual income; performance measurement; lost capital; value-based management; firm valuation; abnormal earnings aggregation (search for similar items in EconPapers)
JEL-codes: G11 G12 G30 G31 M40 M41 M52 (search for similar items in EconPapers)
Date: 2007-09
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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https://mpra.ub.uni-muenchen.de/5850/2/MPRA_paper_5850.pdf original version (application/pdf)
https://mpra.ub.uni-muenchen.de/7158/1/MPRA_paper_7158.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/8387/1/MPRA_paper_8387.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/8939/1/MPRA_paper_8939.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/17417/2/MPRA_paper_17417.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/17538/1/MPRA_paper_17538.pdf revised version (application/pdf)

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