Residual Income

Definition

Residual income, also known as residual return, is the net income that a subsidiary undertaking or division of an organization generates after being charged a percentage return for the book value of the net assets or resources under its control. Headquarters or holding companies use the residual income approach to require subsidiaries or divisions to maximize their profits after accounting for the use of those assets. This approach is similar to the Economic Value Added (EVA) technique.

Examples

Scenario:

A company has two divisions: Division X and Division Y. Both divisions face decisions about investing £1,000,000 in different projects.

Division X:

Proposed investment: £1,000,000
Profit before interest and tax (PBIT): £200,000
Cost of capital: 15%

Division Y:

Proposed investment: £1,000,000
Profit before interest and tax (PBIT): £100,000
Cost of capital: 15%

Calculations:

	Division X (£)	Division Y (£)
Profit before interest and tax	200,000	100,000
Cost of capital charge (15% of £1,000,000)	150,000	150,000
Residual income	50,000	(50,000)

Decision:

Division X: Accept the project (positive residual income of £50,000).
Division Y: Reject the project (negative residual income of £50,000).

Frequently Asked Questions (FAQs)

Q1: What is the difference between residual income and net income?

A: Net income is the total profit of a business after all expenses, including taxes and interest, have been deducted. Residual income, however, deducts an additional cost of capital, reflecting the use of assets.

Q2: How does the cost of capital affect residual income?

A: The cost of capital is subtracted from the profit before interest and tax to calculate residual income. A higher cost of capital reduces residual income, potentially turning a seemingly profitable project into a loss.

Q3: Why might a company prefer residual income over return on capital employed (ROCE)?

A: Residual income is considered to provide a more precise measure of investments’ profitability by accounting for the cost of capital. ROCE, while popular, may not always reflect the true economic profit of an investment.

Q4: Can residual income be negative?

A: Yes, if the profit before interest and tax does not cover the cost of capital, residual income will be negative, signaling that the investment may not be worthwhile.

Q5: Is residual income used in personal finance?

A: Yes, in personal finance, residual income refers to the amount of money one has after all personal debts and obligations are paid. It indicates financial flexibility and health.

Economic Value Added (EVA)

A measure of a company’s financial performance that calculates the value created over and above the required return of its shareholders. EVA is similar to residual income but often used more broadly.

Return on Capital Employed (ROCE)

A financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated by dividing operating profit by capital employed.

Net Income

The total revenue minus all expenses, taxes, and costs, reflecting the company’s profit.

Cost of Capital

The required return necessary to make a capital budgeting project worthwhile. It is the rate of return that could be earned on another investment with similar risk.

Investment Decision

The process of making choices about where to allocate capital resources, including projects, ventures, or asset acquisitions.

Online References

Suggested Books for Further Studies

“Financial Analysis with Microsoft Excel” by Timothy R. Mayes and Todd M. Shank Gives a comprehensive guide on financial analysis including how to calculate and interpret residual income.
“Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran Covers various performance metrics, including residual income, and their applications in investment decisions.
“Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports” by Howard M. Schilit Offers insights on evaluating financial metrics including residual income for detecting true profitability.

Accounting Basics: “Residual Income” Fundamentals Quiz

### What is residual income? - [x] Net income after deducting a percentage return for the book value of net assets. - [ ] Total revenue minus all operating expenses. - [ ] Net income excluding interest and tax. - [ ] Return on capital employed. > **Explanation:** Residual income reflects the net income generated after accounting for a cost of capital charge on the assets used. ### Why is the cost of capital crucial in residual income calculations? - [x] It determines the deducted value affecting the net profitability of investments. - [ ] It increases the asset's book value. - [ ] It remains constant irrespective of project risk. - [ ] It has no effect on residual income. > **Explanation:** The cost of capital is deducted from the profit before interest and tax. This affects the residual income calculation by incorporating the cost of using assets. ### What does a negative residual income indicate? - [x] The project's profit does not cover the cost of capital. - [ ] The net income is high. - [ ] The ROCE is exceptionally high. - [ ] The project should be accepted. > **Explanation:** Negative residual income suggests the project's profit is insufficient to cover the cost of capital, indicating it may not be worthwhile. ### How does residual income differ from Economic Value Added (EVA)? - [x] Both are similar, but EVA is often used more broadly. - [ ] EVA does not consider the cost of capital. - [ ] Residual income is only for personal finance. - [ ] EVA only applies to large corporations. > **Explanation:** Both metrics are similar, but EVA is more broadly applied to measure financial performance across entire organizations. ### In which situation would you prefer using residual income over ROCE? - [x] When measuring the true economic profit of investments, including the cost of capital. - [ ] When ignoring the cost of capital. - [ ] When focusing solely on operating profit. - [ ] When calculating net income. > **Explanation:** Residual income provides a precise measure by including the cost of capital, making it preferable for assessing true economic profit. ### Residual income is especially important for which type of decision? - [x] Investment decisions within larger organizations. - [ ] Day-to-day operational decisions. - [ ] Personal budgeting. - [ ] Payroll management. > **Explanation:** Residual income is crucial for investment decisions, ensuring that projects undertaken maximize profit after capital costs. ### What can cause the residual income of a division to differ from another? - [x] Different cost of capital percentages due to varying risk levels. - [ ] Identical cost structures across divisions. - [ ] Uniform asset usage across all projects. - [ ] Consistent profitability across the board. > **Explanation:** Different divisions may have varying risk levels, leading to different cost of capital percentages and affecting their residual income. ### What must be deducted from PBIT to calculate residual income? - [x] Cost of capital charge. - [ ] Net revenue. - [ ] Operating expenses. - [ ] Taxes. > **Explanation:** To calculate residual income, the cost of capital charge needs to be deducted from the profit before interest and tax (PBIT). ### Can residual income be considered a strong indicator for personal finances? - [x] Yes, it indicates financial health beyond just income and expenses. - [ ] No, it is only relevant for corporate finance. - [ ] Yes, but only for retired individuals. - [ ] No, it only relates to investment portfolios. > **Explanation:** Residual income in personal finance indicates financial flexibility and health after all obligations are met. ### How can managers use residual income to improve divisional performance? - [x] By making informed investment decisions considering the cost of capital. - [ ] By ignoring the cost structure. - [ ] By focusing solely on net income. - [ ] By maximizing revenue without considering expenses. > **Explanation:** Managers can use residual income calculations to make informed investment decisions that account for the cost of capital, optimizing divisional performance.

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