Residual Income

[Raghavsrini]

Hi all, I have a doubt about the calculation of residual income… Why is it based on the book value of equity instead of market value?? Cos WACC is calculated using the market values of debt and equity…

[MrSmart]

RI is used to arrive at the market value of equity. Using the book value of equity as a starting point.

The market value of, well, anything is its current value, plus any expected future benefits discounted at its opportunity cost.

In this case, you start with all your BV, then add any additional income over your cost of equity for that amount of BV, discounted for time-value of money.

The WACC uses a different approach, where it calculates only the future benefits of an asset, discounted at their financing costs of capital (which is naturally, their market value).

[Raghavsrini]

@MrSmart

RI is used to arrive at the market value of equity. Using the book value of equity as a starting point.

The market value of, well, anything is its current value, plus any expected future benefits discounted at its opportunity cost.

In this case, you start with all your BV, then add any additional income over your cost of equity for that amount of BV, discounted for time-value of money.

The WACC uses a different approach, where it calculates only the future benefits of an asset, discounted at their financing costs of capital (which is naturally, their market value).

Finally got it!! Thanks a lot buddy for the explanation…

[MrSmart]

My pleasure.