Residual Income

What is Residual Income?

Residual income, is common concept used in valuation and can be defined as the excess return generated over the minimum rate of return (often referred to as the cost of capital) of the amount of net income.

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Residual Income (wallstreetmojo.com)

Where,

• Equity Charge = Cost of Equity Capital x Equity Capital

Steps by Step Calculation of Residual Income

This clearly shows the economic profit rather than just accounting profit.

Examples

Example #1

MQR Inc. is a listed company. From publicly available records, the net income of the firm is $123,765. The Equity capital of the company is $1,100,000. Assuming, cost of capital of the firm is 10%, you are required to compute the residual income of the company.

Solution

Use the following data for calculation

• Net Income of Firm: 123765.00
• Equity Capital: 1100000.00
• Cost of Capital: 10.00%

We will now calculate equity charge, which is nothing but the cost of equity capital x equity capital, which is $1,100,000 x 10%, which is $110,000.

• Equity Charge = 110000.00

• Residual Income =  Net Income of the firm – Equity Charge
• = 123765.00 – 110000.00

Example #2

Yes, a leasing Company, Inc. (YCI), is a mid-size company in terms of market capitalization, and as per public records, the firm has reported total assets of US$4 million and the capital structure of the firm is Fifty % with equity capital and Fifty % with debt. The company borrows at an average rate of 8 % before taxes, and the interest can be considered tax-deductible. Hence the post-tax cost of debtPost-tax Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more for the firm is 5.6 %. The firm has reported its EBIT, that is, earnings before interest and taxes of US$400,000, and the statutory income tax rate is 30 %. Net income for the firm is per below:

• EBIT of the firmEBIT Of The FirmEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.read more  – US$400,000
• Subtract: Interest Expense – US$140,000
•  Income Before Tax –  US$260,000
• Subtract: Income Tax  – US$  78,000
•  Net Income of firm-  US$182,000

 You can presume that the cost of equity capital is 14 %. US$182,000 is an accounting profit, but was the firm’s profitability enough return for its shareholders? .You are required to compute the residual income approach.

Solution

One method for calculating the residual income is to subtract net income from an equity charge (In monetary terms, the cost of equity, which is the estimated one).We can calculate the charge on equity using the formula discussed.

Use the following data for calculation

First, we need to calculate equity capital

Therefore, calculation of Equity Capital will be as follows,

Total Equity = US$4,000,000 x 50%

• Equity Capital = US$2,000,000

Therefore, calculation of Equity Charge will be as follows,

Equity Charge = Equity capital × Cost of equity capital

= US$2,000,000 × 12%

• Equity Charge = US$240,000.

Residual Income can be calculated using the below formula as,

Residual Income = Net Income of the Firm – Equity Charge

= US$182,000 – US$240,000

As seen from the negative economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more, it can be concluded that YCI has not to earn adequate to cover the equity cost of capital. Although the company is profitable in an accounting sense from the economic sense, it is incurring a loss.

Example #3

A newly incorporated company appears to be a promising company to the investors and the shareholders. It had an equity capital ratio of 60% and 40% debt. The total assets of the firm are US$50,000,000. The Net Profit that was reported was US$4,700,500. Since the company was rated as risky, the cost of capital that was assigned to the firm was 16%. You are required to assess whether the company is making a profit in the economic sense?

Solution

One method for calculating the residual income is to subtract net income from an equity charge (In monetary terms, the cost of equity, which is the estimated one).

Use the following data for calculation

• Net income of Firm: 4700500.00
• Total Assets of Firm: 50000000.00
• Equity Capital Ratio: 60%
• Cost of Capital: 16%

First, we need to calculate equity capital

Therefore, calculation of Equity Capital will be as follows,

Total Equity  = US$50,000,000 x 60%

• Equity Capital = US$30,000,000

Therefore, calculation of Equity Charge will be as follows,

Equity Charge = Equity capital × Cost of equity capital

= US$30,000,000 × 16%

• Equity Charge = US$4,800,000

Residual Income can be calculated using the below formula as,

Residual Income = Net Income of the firm – Equity charge:

= US$4,700,500  – US$4,800,000

As seen from the negative economic profit, it can be concluded that AEW has not to earn adequate to cover the equity cost of capital. Although the company is profitable in an accounting sense from the economic sense, it is incurring a loss.

Residual Income Calculator

You can use this calculator

Relevance and Uses

The income statement prepared traditionally was to reflect the owners or the shareholders the earnings available to them. Therefore, the statement of income depicts net profit after accounting for an interest expense for the debt cost of capital. There was no deduction for dividends or any other charges for the equity capital in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. Henceforth, it was up to the owners to conclude whether their funds are earning economically in those conditions.

On the flip side, economically sensible, the residual income explicitly accounts for shareholder’s opportunity cost and hence subtracts the estimated cost of equity capital. The required rate of return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more is the marginal cost of equity. The cost of equity can be considered as marginal costMarginal CostMarginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit. It is calculated by dividing the change in the costs by the change in quantity.read more as it shall represent the additional cost of equity, be it by selling more interests of equity or internally generated. This concept is the majority used in valuation when the residual income approach is preferred.

Recommended Articles

This article has been a guide to Residual Income and its definition. Here we discuss the calculation of the residual income using its formula and downloadable excel template. You can learn more about economics from the following articles –

• Economic Profit Formula
• Pretax Income Formula
• What is Operating Income?
• What is Accrued Income?