Economic profitability and

(non)additivity of residual income

*
Carlo Alberto Magni
Dept. of Economics “Marco Biagi”
University of Modena and Reggio viale Berengario 51, 41100 Modena
School of Doctorate E4E
(Engineering for Economics − Economics for Engineering)
https://orcid.org/0000-0003-3066-8426
magni@unimo.it

Abstract

We show that the standard notion of residual income (RI) does not fulfill additive coherence.
This gives rise to ambiguities and inconsistencies. The pitfall resides in the capital charge, which
blends a non-market value with a market rate. We solve the problem by using a capital charge
based on economic return, obtained as the product of a market value and a market rate. The
resultant economic RI enjoys additivity. The economic RI is naturally associated to the average
Return on Investment (ratio of total income to total invested capital). Subtracting the respective
cost of capital (ratio of total economic return to total invested capital) the marginal economic
efficiency of the capital is correctly captured. Economic RI guarantees consistency among the
various sets of incomes, book values, economic values, accounting rates, and costs of capital, under
an investment perspective as well as a financing one, both at a period level and at an aggregate
level, either assuming time-invariant or time-varying costs of capital. Therefore, the economic RI
offers a coherent tool for the assessment of a project’s or firm’s economic efficiency.

Keywords. Accounting and finance, residual income, economic value, net present value, non-
additivity, inconsistencies.

JEL codes. G30, G31, G10, G11, M41

*
The author thanks Ken Peasnell for his helpful remarks on a draft of this paper.

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1 Introduction
The residual income is a period measure of economic profitability for projects and firms. The notion
of residual income (RI) has a venerable ancestry. Variously labeled as excess profit, abnormal
earnings, residual earnings, excess income, surplus profit, excess return, its conception traces back
to Marshall (1890), possibly inspired by Hamilton (1777), and has attracted attention since the
1930s (Preinreich 1936, 1937, 1938). In later years, the connection between RI and economic value
was made more explicit since Edey (1957), Edwards and Bell (1961), Bodenhorn (1964), and its
overall consistency with the net present value (NPV) has been precisely clarified by many scholars
(e.g., Peasnell 1981, 1982a, Peccati 1989, Stewart 1991, Ohlson, 1995, Martin and Petty, 2000;
Hartman 2000, Lundholm and O’Keefe, 2001, Fernández 2002, Martin et al 2003, Magni 2009).
Given an amount invested in a firm or in a project at the beginning of a period, the RI is the
profit over and above the alternative profit that could be obtained by an investor investing the
same amount in a normal (i.e., perfect and efficient) market. This alternative profit is often called
the capital charge and is obtained as the product of the beginning-of-period invested capital (book
value) and the expected rate of return on an asset traded in the market equivalent in risk to the
project under consideration. This rate of return is the cost of capital ; depending on the perspec-
tive, it expresses the cost of equity capital (equityholders’ perspective), the cost of debt capital
(debtholders’ perspective), the weighted average cost of capital (capital providers’ perspective),
the unlevered cost of assets (unlevered perspective) (see Modigliani and Miller 1958, 1963, Miller
and Modigliani 1961. See also Cooper and Nyborg 2007, Ross, Westerfield and Jordan 2011, Berk
and DeMarzo 2014).
However, it has gone largely unnoticed by scholars that the RI notion does not comply with
value additivity, a basic tenet in finance and a necessary property for reliable financial analysis.
In particular, from an investment perspective, the RI of a portfolio of projects is not equal to the
sum of the RIs of the projects. Since a firm may be viewed as a portfolio of projects, this also
means that a firm’s RI is not equal to the RIs of its constituent projects. Symmetrically, under a
financing perspective, a project’s RI or a firm’s RI is not equal to sum of the RIs of equity and
debt. Analogously, a project’s or firm’s RI is not the sum of the residual operating income and
residual financial income and the residual earnings is not the difference between the project’s firm’s
RI and the residual financial expense. This raises an issue of ambiguity and inconsistency and casts
a shadow on the usefulness of the RI notion as such.
We show that the problem of the RI notion lies in the capital charge, which mixes book values
with economic (i.e., market) rates. We solve the problem by replacing book values with economic
values. The resultant economic RI fulfills value additivity.
Further, the sum of the project’s undiscounted RIs is equal to the project’s NPV and this enables
accomplishing an unambiguous decomposition of a firm’s or project’s economic value created, under
an investment perspective (operating investments and financial investments) as well as a financing
perspective (debt and equity).
Moreover, the economic RI is associated with the internal average rate of return (ratio of
total project income to total invested capital) which correctly captures economic profitability when
compared to an appropriate cost of capital (ratio of total economic return to total invested capital).
The average rate is precisely internal, for it does not depend on the market rates, and takes the
form of (i) an average Return On Investment (ROI) in an investment perspective, (ii) an average
Return On Equity (ROE) in an equityholder perspective, and (iii) an average Return On Debt

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(ROD) in a debtholder perspective.
This approach enables reconciling, in an easy way, the notion of RI with the notions of economic
rate of return and NPV and, therefore, the related notion of economic value created.
The remainder of the paper is structured as follows. Section 2 shows that the standard definition
of RI does not fulfill value additivity. Section 3 introduces the economic RI, which heals the
difficulties of the standard RI. Section 4 shows that the economic RI is associated with an average
rate of return which correctly measure a project’s or firm’s overall economic profitability. Section 5
presents an example of analysis of economic profitability at a period level and at an aggregate level,
under both an investment perspective and a financing perspective, alternatively assuming time-
invariant cost of capital and time-varying costs of capital; an additional example takes explicit
account of taxes. Section 6 shows the necessary and sufficient conditions under which the standard
RI is additive. Some remarks conclude the paper.

2 Non-additivity of residual income

Residual income (RI) is an established notion in accounting and finance (Peasnell 1981, 1982a,b,
Brief and Peasnell 1996, Magni 2009). Let P be a project (or firm), and denote the estimated
income at time t as It , the estimated book value capital at time t − 1 (beginning of period [t − 1, t]
as Ct−1 , and the cost of capital as rt . Then, the RI as of time t, which we denote as RIt , is
traditionally defined as
RIt = It − rt · Ct−1 . (1)

Equation (1) can also be framed as RIt = (it − rt ) · Ct−1 , where it = It /Ct−1 is the return on
investment (ROI). The project’s prospective cash flows are computed from incomes and capital
amounts as
Ft = It − ∆Ct t = 1, . . . , n (2)

with F0 = −C0 , Cn = 0, and where ∆Ct = Ct − Ct−1 is the change in capital. Let F~ =
(F1 , F2 , . . . , Fn ) denote the vector of the prospective cash flows of a project P .
We assume that a normal (i.e., perfect and efficient) market exists where risk may be hedged
by existing securities. Let rt be the expected holding period rate of a traded asset equivalent in
risk to project P . This is also known as risk-adjusted cost of capital (COC) and expresses the
minimum acceptable rate of return for undertaking P . The project’s market or economic value at
time t is such that Vt = Vt−1 (1 + rt ) − Ft or, equivalently, Vt = (Vt+1 + Ft+1 )/(1 + rt+1 ), which
Pn
implies Vt = s=t+1 Fs ds,t , where ds,t = [(1 + rt+1 )(1 + rt+2 ) · . . . · (1 + rs )]−1 , is the discounting
factor, with s > t and dt,t = 1. Put simply, the economic value of the project is “the price the
project would have if it were traded” (Mason and Merton 1985, pp. 38-39); V0 is then the amount
of money that should be invested in the security market for replicating the project’s cash-flow
stream F~ . The net present value (NPV) is the difference between the project’s value at time 0 and
the initial investment, equal to initial book value: NPV = V0 − C0 . It is well-known that overall
consistency of the RI notion with the net present value (NPV) holds:
n
X n
X
NPV = V0 − C0 = Ft · dt,0 = RIt · dt,0 (3)
t=0 t=1

(see proof in eq. (17)).

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Consider two projects, h and k, whose expected cash-flow streams are F~ h = (F1h , F2h , . . . , Fnh ) and
F~ k = (F1k , F2k , . . . , Fnk ), and let F~ h+k = F~ h + F~ k be the cash-flow stream of the portfolio of the
two projects, here labeled as h + k. Let Vth , Vtk , Vth+k denote their respective economic values.
In a normal market, the law of one price holds, which implies value additivity, that is, the
economic value of the portfolio is equal to the sum of the economic values of the two constituent
assets:
Vth + Vtk = Vth+k (4)
(we crossrefer to Robichek and Myers 1966, Haley and Schall 1979, Berk and DeMarzo 2014, Ross,
Westerfield and Jordan 2011, or any finance text for details on value additivity and the related law
of one price. See also Modigliani and Miller 1958, Miller and Modigliani 1961.) We let rh and rk
be the (assumed constant) required return on project h and k, respectively. In general, assuming
the projects have different risks, rh 6= rk . Using value additivity,
Vh
t t Vk t V h+k
z }| { z }| { z }| {
h h h k k k h+k h+k h+k
Vt−1 (1 + r ) − Ft + Vt−1 (1 + r ) − Ft = Vt−1 (1 + rt ) − Ft

whence
rh Vt−1
h
+ rk Vt−1
k
rth+k = h k
. (5)
Vt−1 + Vt−1
Thus, the required return on portfolio h + k is the value-weighted mean of the expected returns on
the constituent assets, h and k. Note that, even assuming constant COCs for rh and rk , the COC
of the portfolio, rth+k , will be, in general, time-varying.
Let portfolio h + k be financed with equity and debt. In particular, let F~ e = (F1e , F2e , . . . , Fne )
and F~ d = (F1d , F2d , . . . , Fnd ) be the prospective equity cash flow stream and debt cash flow stream,
respectively, such that F~ h+k = F~ e + F~ d . The portfolio may then be viewed as a portfolio of
equity and debt, so that its cash-flow stream is F~ e+d = F~ e + F~ d , which implies F~ e+d = F~ h+k . In
other words, a firm or portfolio of projects may be interpreted under two different perspectives:
Investment perspective (portfolio of h and k) or financing perspective (portfolio of e and d). Let
rte be the required return on equity, expressing the expected rate of return on a financial asset
replicating the equity cash flow stream; let rtd be the required return on debt, expressing the
expected rate of return on a financial asset replicating the debt’s cash flow stream. Let Ite and I d
be the firm’s net income and financial expenses at time t, respectively and Cte and Ctd be the firm’s
equity capital and debt capital at time t, respectively. Then, RIet = Ite − rte Ct−1 e
is the residual
d d d d e+d
earnings and RIt = It − rt Ct−1 the residual financial expense. RIt is the residual income of the
portfolio of equity and debt.
By value additivity, all the economic values balance out: Vth+k = Vth + Vtk = Vte + Vtd = Vte+d .
Hence, the costs of capital balance out as well:
rh Vt−1
h
+ rk Vt−1
k
h+k e+d rte Vt−1
e
+ rtd Vt−1
d

h +Vk
= rt = rt = e +Vd
. (6)
Vt−1 t−1 Vt−1 t−1

The rate rte+d = rth+k is the so-called weighted average cost of capital (WACC). Henceforth, we will
use the symbol rt to denote it. Note that, in general, even if the cost of equity and the cost of debt
are constant (rte = re and rtd = rd ), the project’s cost of capital, rt , is time-varying.
Using (6), we can now state the following proposition.
Proposition 1 (Non-additivity of (standard) Residual Income). The standard Residual Income,
RIt = It − rt Ct−1 is non-additive. In particular,

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 ˆ under an investment perspective, RIht + RIkt 6= RIh+k
ˆ under a financing perspective: RIet + RIdt 6= RIe+d .

Proof. Let Cth and Ctk be the invested capital amounts for h and k and let Ith , Itk be the respective
incomes. The RI of h + k is not equal to the sum of the RIs of h and k:

RIht + RIkt = (Ith − rh Ct−1

h
) + (Itk − rk Ct−1
k
)
rh Ct−1
h
+ rk Ct−1
k
= Ith + Itk − h k
h
· (Ct−1 k
+ Ct−1 )
Ct−1 + Ct−1
rh Vt−1
h
+ rk Vt−1
k
(7)
6= Ith + Itk − h k
h
· (Ct−1 k
+ Ct−1 )
Vt−1 + Vt−1
= Ith + Itk − rth+k (Ct−1
h k
+ Ct−1 )
= RIh+k .

This proves the first part of the proposition.

Analogously, the RI of e + d is not equal to the sum of the RIs of e and d:

RIet + RIdt = (Ite − rte Ct−1

e
) + (Itd − rd Ct−1
d
)
rte Ct−1
e
+ rtd Ct−1
d
= Ite + Itd − e d
e
· (Ct−1 d
+ Ct−1 )
Ct−1 + Ct−1
e
rte Vt−1 d
+ rtd Vt−1 (8)
6= Ite + Itd − e +Vd
e
· (Ct−1 d
+ Ct−1 )
Vt−1 t−1

= Ite + Itd − rte+d (Ct−1

e d
+ Ct−1 )
= RIe+d .

This concludes the proof.

The non-additivity shown in Proposition 1 detracts from the economic meaningfulness of the RI
notion. Note that the non-additivity is twofold, since it applies to both investment and financing
sides. Thus, it supplies two sources of ambiguities and related inconsistencies. More precisely, the
following three inequalities arise:
RIte+d 6= RIet + RIdt
RIet + RIdt 6= RIh + RIkt (9)
h
RI + RIkt h+k 1
6= RI .
It is not clear which of the three RIs should be the relevant RI.
In light of what we have shown, the RI generated in a period by a given portfolio of investments is
not the same as the sum of the RIs created by the portfolio’s constituent assets, RIht +RIkt . And none
of the two is equal to the sum of the residual earnings and the residual financial expense. Additive
coherence is a preliminary requirement for any notion aiming at measuring period performance.
Since the standard RI measures above-normal returns in an ambiguous way, it does not reliably
perform the task for which it has been conceived.

The problem of RI lies in the capital charge, rt Ct−1 , which mixes economic rates of return and
non-economic (i.e., pro forma book) values. An economic rate rt is associated with economic values
1
Note that, contrary to the above inequalities, the equality RIe+d = RIh+k does hold because rte+d = rth+k (by law of
one price) and C e+d = C h+k (because investments and financings always equate).

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Vt : rt = (Vt + Ft − Vt−1 )/Vt−1 , so that rt Vt−1 = Rt is an economic profit. By blending a market
rate rt and a non-market value Ct , one erroneously builds a non-additive capital charge, rt Ct−1 :

rt Ct−1 6= rte Ct−1

e
+ rtd Ct−1
d

rte Ct−1
e
+ rtd Ct−1
d
6= rth Ct−1
h
+ rtk Ct−1
k

rth Ct−1
h
+ rtk Ct−1
k
6= rt Ct−1

(see Section 3 below). This in turn causes the RI to be non-additive. This raises the issue of how
to amend the RI notion and provide a more robust RI notion which fulfills value additivity and
avoids ambiguities and inconsistencies.

3 The economic RI
In this section, we amend the problem raised by the standard RI notion and introduce the notion
of economic RI, which fulfills additivity. As anticipated, the problem lies in the capital charge,
rt Ct−1 , which mixes apples (economic rate) and oranges (pro forma book value). The following
inequalities arise:

rh Ct−1
h
+ rk Ct−1
k
rh Ct−1
h
+ rk Ct−1
k
= h k
h
· (Ct−1 k
+ Ct−1 )
Ct−1 + Ct−1
rh Vt−1
h
+ rk Vt−1
k
h k
6= h +Vk
· (Ct−1 + Ct−1 )
Vt−1 t−1

= rth+k Ct−1
h+k

and
rh Ct−1
h
+ rk Ct−1
k
rh Ct−1
h
+ rk Ct−1
k
= h k
h
· (Ct−1 k
+ Ct−1 )
Ct−1 + Ct−1
rte Ct−1
e
+ rtd Ct−1
d
e d
6= e d
· (Ct−1 + Ct−1 )
Ct−1 + Ct−1

and
rte Ct−1
e d
+ rtd Ct−1
rte Ct−1
e
+ rtd Ct−1
d
= e d
e
· (Ct−1 d
+ Ct−1 )
Ct−1 + Ct−1
e
rte Vt−1 + rtd Vt−1
d
e d
6= e +Vd
· (Ct−1 + Ct−1 )
Vt−1 t−1

= rte+d Ct−1
e+d

The problem is naturally solved by using apples with apples and oranges with oranges; metaphors
aside, this means that one should use economic rates of return with economic values instead of
economic rates of return with non-economic (i.e., book) values.
In the following, we supply the financial interpretation of the economic RI and, in particular,
of its capital charge; then, we define it formally and then we prove that it is additive and NPV-
consistent.
Consider that the investor may invest in the project with an expected stream of prospective cash
flows F~ such that C~ is the stream of invested amounts and I~ is the income stream. Alternatively,
the investor may invest in an equal-risk replicating portfolio with the same cash-flow stream F~

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 ~ is the stream of invested amounts and R
such that V ~ is the return stream, where It is the project’s
income and Rt = rt Vt−1 is the market return on the portfolio replicating the project’s prospective
cash flows, and ∆C~ = (∆C1 , ∆C2 , . . . , ∆Cn ) and ∆V
~ = (∆V1 , ∆V2 , . . . , ∆Vn ) are the respective
change in invested capital (see table below). The replicating portfolio acts as a benchmark portfolio,

Table 1: Economic RI and the alternative scenarios

Project (firm) scenario Benchmark scenario

~ = (C0 , C1 , . . . , Cn−1 )
C ~
V = (V0 , V1 , . . . , Vn−1 )
(book values) (economic values)

I~ = (I1 , I2 , . . . , In ) ~ = (R1 , R2 , . . . , Rn )
R
(accounting income) (economic income)

F~ = (F1 , F2 , . . . , Fn ) F~ = (F1 , F2 , . . . , Fn )
(project cash flows) (replicating portfolio’s cash flows)
~i = (i1 , i2 , . . . , in ) ~r = (r1 , r2 , . . . , rn )
(accounting rates) (economic rates)

F~ = I~ − ∆C
~ F~ ~ − ∆V
=R ~

that is, in each period, if investors invest Ct−1 at the rate it (project scenario), then they renounce
to invest Vt−1 at the rate rt (benchmark scenario). (See Table 1.) We now give the following
definition of economic residual income.

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 Definition 1 (Economic Residual Income). The (time-t) economic residual income is the difference
between the profit, It , and the return of the benchmark (replicating) portfolio, Rt . We denote it as
ERIt :
ERIt = It − Rt = It − rt Vt−1 . (10)
~ = (800, 400, 200, 0)
As a simple example, consider a 3-period firm or project with book value capital C
~
and profits equal to I = (100, 50, 30) at time t = 0, 1, 2, 3 respectively. Hence, the firm’s prospec-
tive cash-flow stream is F~ = (500, 250, 230) with F0 = −C0 = −800.2 Assuming a 10% cost
of capital, the economic values (i.e., discounted sum of the prospective cash flows at 10%) are
~ = (833.96, 417.36, 209.09, 0).3 Multiplying the first three economic values by 10%, the economic
V
capital charges are found: R1 = 83.4, R2 = 41.74, and R3 = 20.91 for the first, second, and third
period, respectively. Subtracting these figures from the incomes I1 = 100, I2 = 50, I3 = 30, re-
spectively, one gets the economic RIs: ERI1 = 16.6, ERI2 = 8.26, and ERI3 = 9.09, whose sum
coincides with the NPV, equal to NPV = 33.95.

In general, consider the expected returns of three benchmark portfolios replicating the prospec-
tive cash flows of h, k, and h + k (investment side), respectively and three benchmark portfolios
replicating the prospective cash flows of e, d, and e+d (financing side). We now show that additivity
of economic RI holds.

Proposition 2 (Additivity of economic RI). Economic RI is additive. In particular

ˆ under an investment perspective, ERIht + ERIkt = ERIh+k
t

ˆ under a financing perspective, ERIet + ERIdt = ERIte+d

(as well as ERIe+d
t = ERIth+k ).

Proof. Consider a portfolio of projects h and k, financed with equity and debt. Note that, under an
investment perspective, both the project’s income and the associated economic return are additive.
As for the project’s income, this derives from the definition of income:

Ith + Itk = Ith+k . (11)

As for the economic profits, they derive from (5):

Rth + Rtk = rh Vt−1

h
+ rk Vt−1
k
= rth+k Vt−1
h+k
= Rth+k . (12)

Hence,
ERIht + ERIkt = Ith − Rth + Itk − Rtk
= Ith + Itk − (Rth + Rtk )
= I h+k − (Rth + Rtk ) [by additivity of It ] (13)
= Ith+k − Rth+k [by additivity of Rt ]
= ERIh+k
t .
This proves the first part of the proposition. Analogously, considering the sources of financing
(equity and debt), the capital charges are Rte = rte · Vt−1
e
, Rtd = rtd · Vt−1
d
, Rte+d = rte+d · Vt−1
e+d
,
2
Cash flow is found as the sum of income and change in book value: Ft = It − ∆Ct = It − (Ct − Ct−1 ) (see eq. (2)).
3
For example, V1 = 417.36 = 250/1.1 + 230/1.12 .

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respectively. Hence,

ERIet + ERIdt = Ite − Rte + Itd − Rtd

= Ite + Itd − (Rte + Rtd )
= I e+d − (Rte + Rtd ) [by additivity of It ] (14)
= Ite+d − Rte+d [by additivity of Rt ]
= ERIe+d
t .

Also, ERIh+k
t = ERIte+d . Therefore, we may write

ERIe+d
t = ERIet + ERIdt = ERIht + ERIkt = ERIh+k
t . (15)

This allows us to use a common symbol, ERIt to refer to the project’s RI, without any ambiguity
(see Table 2). Now we show that the NPV consistency of the economic RI holds in a surprisingly

Table 2: Economic RI of firm/portfolio P

INVESTMENT SIDE FINANCING SIDE

Residual
financial expense
Residual operating income (ERIdt )
project h
(ERIht )

Residual earnings

Residual operating income (ERIet )

project k
(ERIkt )

simple way.

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Proposition 3 (NPV-consistency of ERI). The sum of the undiscounted project’s economic resid-
ual incomes is equal to the NPV:
Xn
ERIt = NPV.
t=1
Pn
Therefore, a project creates value is created if and only if t=1 ERIt > 0.
Pn Pn
Proof. Let I = t=1 It and R = t=1 Rt . Considering that Ft = It − ∆Ct = Rt − ∆Vt (see also
Table 1),
n
X
ERIt =I −R
t=1
Pn Pn
= t=1 (Ft + ∆Ct ) − t=1 (Ft + ∆Vt )
(16)
= (∆C1 + . . . + ∆Cn ) − (∆V1 + . . . + ∆Vn )
= V0 − C0
= NPV.

This result shows that the economic RI enables one to interpret the NPV as an overall (economic)
residual income, that is, a difference between the project’s total profit and the total economic return.
The NPV is then the total profit over and above the profit that could be earned by the investors
by investing in a benchmark portfolio instead of undertaking the project.
Note that no discounting is needed to reconcile RI and NPV. Note also that (3) and (16) imply
that the sum of undiscounted economic RIs is equal to the sum of discounted standard RIs. A
direct proof is as follows:
n
X
ERIt = [from (16)] = NPV
t=1
n
X It − Ct + Ct−1
= Qt + F0
t=1 j=1 (1 + rj )
n n
X Ct − Ct−1
X It
= Qt − Qt + F0
t=1 j=1 (1 + rj ) t=1 j=1 (1 + rj )
n n
X Ct − Ct−1
X It
= Qt − Qt − C0
t=1 j=1 (1 + rj ) t=1 j=1 (1 + rj )
n n n (17)
X It X Ct−1 X Ct
= Qt + Qt − C0 − Qt
t=1 j=1 (1 + rj ) t=1 j=1 (1 + rj ) t=1 j=1 (1 + rj )
n n  
X It X Ct−1 1
= Qt + Qt−1 −1
t=1 j=1 (1 + rj ) t=1 j=1 (1 + rj )
1 + rt
n
X It − rt Ct−1
= Qt
t=1 j=1 (1 + rj )
n
X
= RIt · dt,0 .
t=1

Note also that a breakdown of NPV is obtained in both an investment perspective and a financing
perspective:
NPVh + NPVk = NPV = NPVe + NPVd (18)

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 Pn Pn
where NPVj = V0j − C0j = t=0 Ftj dt,0 for j = h, k, e, d and t=1 ERIj = NPVj .
Remark 1 (Benchmark scenarios). The standard RI and the economic RI are both based on a
comparison of the project with an alternative benchmark scenario which is built upon a replicating
portfolio. However, this portfolio is different in the two approaches.
More precisely, in the standard approach, the benchmark scenario consists of investing in the
market an amount equal to the project’s book value, Ct−1 , at the rate rt at the dates t = 0, 1, . . . , n−
1. This means that the investor may alternatively invest in a portfolio replicating the project’s book
values. Hence, the replicating portfolio’s cash flow at time t, Ft∗ , must be different from the project’s
cash flow. Specifically, Ft∗ = rt Ct−1 − (Ct − Ct−1 ),4 with F0∗ = F0 = −C0 .
In contrast, in the economic approach, the benchmark scenario consists of receiving the same
project’s expected cash flows, Ft , t = 1, 2, . . . , n. This means that the investor may alternatively
invest in a portfolio replicating the project’s prospective cash flows. Hence, in general, the repli-
cating portfolio’s value at time t, Vt , must be different from the project’s book value. Specifically,
Vt = (Vt+1 + Ft )/(1 + rt ) with Vn = 0.
Put differently,
ˆ in the standard approach, the benchmark scenario entails investing the same amounts of
capital as the project’s but receiving different cash flows
ˆ in the economic approach, the benchmark scenario entails investing different amounts of
capital from the project’s but receiving the same prospective cash flows.
In both cases, the replicating portfolio is a value-neutral (i.e., zero-NPV) asset, by construc-
tion. Specifically, as for the economic approach, the replicating portfolio cash-flow stream is
Pn Pn
(−V0 , F1 , F2 , . . . , Fn ). Since t=1 Ft dt,0 = V0 , the NPV of the portfolio is t=1 Ft dt,0 − V0 = 0.
As for the standard approach, the replicating portfolio’s cash-flow stream is (−C0 , F1∗ , F2∗ , . . . , Fn∗ ).
Since F0 = F0∗ = −C0 and

Ft − Ft∗ = Ft + (Ct − Ct−1 ) − rt Ct−1 = It − rt Ct−1 = RIt

for every t ≥ 1, whence Ft∗ = Ft − RIt . Therefore, using (3), the NPV of the portfolio is
NPV NPV
z }| { z }| {
n
X n
X n
X Xn n
X
F0∗ + Ft∗ dt,0 = F0 + Ft dt,0 − RIt dt,0 = Ft dt,0 − RIt dt,0 = 0.
t=1 t=1 t=1 t=0 t=1

♦
Remark 2. Suppose financial assets are present in addition to operating assets (projects h and k),
a situation which is rather common in several projects and firms.5 In this case, things worsen,
because 5 inconsistent RIs may be calculated, depending on the way one describes the firm:

RIte+d 6= RIet + RIdt

RIet + RIdt 6= RIht + RIkt + RIft
(19)
RIh + RIht + RIf 6= RIh+k
t + RIft
RIh+k
t + RIft 6= RIth+k+f
4
This derives from the fact that the portfolio’s cash flow must necessarily be equal to the portfolio’s return net of
change in invested capital.
5
This situation arises whenever the cash flows generated by the operations are not entirely distributed to claimholders
but are retained as cash or marketable securities.

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 where RIf denotes the (standard) residual financial income.6 The same situation arises whenever
a firm is divided in two or more business units: The standard residual income of the firm is not
equal to the sum of the RIs of the constituent business units. Analogous is the case when, in a
financing perspective, one classifies financings into more than two classes (e.g., long-term debt,
short-term debt, and equity). In general, there are as many project’s or firm’s RIs as there are
ways of segmenting a project’s (firm’s) investments or financings. In other words, the standard RI
is not invariant under changes in the description of the same project/firm. ♦
In the next section, we show that the economic RI naturally gives rise to the average ROI and
average ROE introduced in Magni (2020) as reliable multiperiod measures of economic efficiency.

4 Average Return On Investment (ROI)

We reframe (16) as NPV = I − R = C · (ῑ − ρ̄) where
Pn Pn
I t=1 It it Ct−1
ῑ = = Pn = Pt=1
n (20)
C t=1 Ct−1 t=1 Ct−1

is the average ROI, expressing the project’s overall rate of return, and
Pn Pn
R t=1 Rt ρt Ct−1
ρ̄ = = Pn = Pt=1 n (21)
C t=1 Ct−1 t=1 Ct−1

expresses the overall cost of capital (COC), with ρt = Rt /Ct−1 . This implies that a project’s NPV
is positive if and only if ῑ > ρ̄. This establishes the economic significance of the average ROI.
As such, the NPV is a function of the project’s economic efficiency ῑ − ρ̄, and the project’s scale,
C. Intriguingly, this measure does not suffer from the several pitfalls associated with the IRR,
including inexistence and multiplicity.7 Also, it is a genuinely internal metric, not affected by the
market rates8
In section 3, we have shown that the additivity of the economic RI enables breaking down
the project’s NPV under both an investment perspective and a financing perspective (see eq. (18)).
Using the average ROI and the related COC, one may frame the NPVs of the two assets as products
of scale and economic efficiency:

NPV = C(ῑ − ρ̄) = C h (ῑh − ρ̄h ) + C k (ῑk − ρ̄k ) (22)

| {z } | {z }
NPVh NPVk

where ῑh = I h /C h and ῑk = I k /C k are the average ROIs of project h and k, respectively, and
ρ̄h = Rh /C h and ρ̄k = Rk /C k are the COCs of project h and k, respectively. The portfolio’s
average ROI, ῑ (respectively, ρ̄), may then be viewed as the weighted mean of ῑh and ῑk (respectively,
ρ̄h and ρ̄k ):
ῑh C h + ῑh C h ρ̄h C h + ρ̄k C k
ῑ = , ρ̄ = . (23)
Ch + Ch Ch + Ck
6
That is, the difference between financial income and the profit generated by a financial asset replicating the cash
flows deposited into and withdrawn from the financial assets (see Magni 2020, Ch. 2).
7
See Magni (2020) for a compendium of pitfalls of IRR, including non-additivity.
8
This rate of return is not to be confused with the Average Internal Rate of Return (AIRR), which is associated with
the standard RI and, as such, utilizes discounting (see Magni 2020). See also Magni (2021) for a thorough analysis of
this rate of return.

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 Likewise, under an investment perspective, the NPVs of equity and debt may be expressed as
products of scale and economic efficiency:

NPV = C · (ῑ − ρ̄) = C e · (ῑe − ρ̄e ) + C d · (ῑd − ρ̄d ) (24)

| {z } | {z }
NPVe NPVd

where ῑe = I e /C e and ῑd = I d /C d are, respectively, the average Return On Equity (ROE) and
average Return On Debt (ROD), while ρ̄e = Re /C e and ρ̄e = Rd /C d are the respective equity
COC and debt COC. The rate ı̄ (respectively, ρ̄) may then be viewed as the weighted mean of ı̄e
and ı̄d (respectively, ρ̄e and ρ̄d ):

ῑe C e + ῑd C d ρ̄e C e + ρ̄d C d

ῑ = , ρ̄ = . (25)
Ce + Cd Ce + Cd
Also, in terms of economic efficiencies,

(ῑh − ρ̄h )C h + (ῑk − ρ̄k )C k

ῑ − ρ̄ =
Ch + Ck
(26)
(ῑ − ρ̄ )C e + (ῑd − ρ̄d )C d
e e
ῑ − ρ̄ = .
Ce + Cd
Note that the scale is unambiguously calculated: C e + C d = C h + C k = C h+k = C e+d , so its
meaning is univocal: It is the total capital invested in the project, and it does not change under
differences in the perspective adopted. It is internal, for it does not depend on the market rate,
which only affects the economic efficiency (via ρ̄). Conversely, the standard RI does not provide an
unambiguous scale, because discounting is necessary to reconcile RI with NPV. In particular,
e+d
Cte det,0 + Ctd ddt,0 6= Cte+d dt,0
Cth dht,0 + Ctk dkt,0 6= Cth+k dh+d
t,0 (27)
Cte det,0 + Ctd ddt,0 6= Cth dht,0 + Ctk dkt,0 .

Inequalities keep on holding if the capital amounts are summed through 0 to n − 1, which implies
that the discounted sum of the capitals are inconsistent, thereby failing in making the notion of
invested capital (and, therefore, scale) unambiguous.

Equations (22)-(26) provide significant and unambiguous financial and managerial insights, not
only in terms of how shareholder value is created by the investment policy on one hand and by the
financing policy on the other hand, but also in terms of value creation or destruction as being the
result of a high scale and a small efficiency or a small scale and a high efficiency. In particular,
(a) ῑh − ρ̄h measures the operating efficiency of project h; C h measures its scale
(b) ῑk − ρ̄k measures the operating efficiency of project k; C k measures its scale
(c) ῑe − ρ̄e measures the efficiency of the equity investment; C e measures its scale
(d) ῑd − ρ̄d measures the efficiency of the borrowing policy; C d measures its scale9
(e) ῑ − ρ̄ measures the portfolio’s efficiency; C measures its scale.
9
If ῑd = ρ̄d , the financing policy is value-neutral. This equality holds in a normal market, but, in real life, some kind
of inefficiency may arise which makes id differ from rd . If ῑd − ρ̄d > 0, debtholders’ NPV is positive and the equity NPV
is smaller than the project’s NPV, so, from the point of view of shareholders, financing is inefficient (see (28)). This
means that the firm borrows from a lender which requires a higher interest rate than the one prevailing in the normal
market. Despite this inefficiency, shareholder value increases if the project’s NPV is sufficiently high and/or the total

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 The shareholder value created, NPVe , may be broken down as follows in terms of investment and
borrowing:
NPVe = C h (ῑh − ρ̄h ) + C k (ῑk − ρ̄k ) − C d (ῑd − ρ̄d ). (28)

Remark 3. It is worth noting that NPV = (ῑ − ρ̄)C = ῑC − r̄V , where r̄ = R/V . The comparison
of the alternative rates of return ῑ and r̄ does not provide correct information about economic
profitability, because they are relative measures of worth; that is, they are ratios which refer to
different capital bases (different invested amounts). Relative measures of worth are comparable
only if scales are equal (see Keane 1979). If V = C, ῑ and r̄ may be compared; if V 6= C, the
market return, R, must be expressed as per unit of invested capital.
The project COC, ρ̄, may also be framed as ρ̄ = r̄(V /C), where V /C represents a necessary
rescaling so that it may be reliably compared with ῑ to correctly capture economic profitability.
In other words, if the firm invested in the replicating portfolio, it would earn r̄ on a capital which
would exceed (or fall short of) the book value by (V − C)/C. The latter indicates by how much
the economic value exceeds (or fall short of) the project’s book value and, therefore, takes account
of the additional market return earned on such additional capital: ρ̄ = r̄V /C = r̄ + r̄(V − C)/C.10
For example, letting r̄ = 10%, V = 1, 000, C = 800, an investor investing a total of 800 in the
project foregoes the opportunity of investing 800 in the market at a 10% return and also foregoes
the opportunity of earning 10% on an additional 25% (= (1, 000 − 800)/800) capital, so that
ρ̄ = 10% + 10% · 25% = 12.5%. ♦
Remark 4. Computationally, V requires calculation of the economic values, Vt . However, the calcu-
lation of the economic values for computing the economic RI is extremely simple. In a spreadsheet,
it takes few seconds to write the code Vt = (Vt+1 + Ft+1 )/(1 + rt+1 ) and then copy and paste
n times in the n cells of the same row (or columns) which express time. The resultant cells will
provide the economic values.
Pn
Actually, it is not even necessary to compute all economic values. Since I = F = F0 + t=1 Ft ,
the average ROI may be framed as ratio of net cash flow to total book values: ῑ = F/C. Also, since
Pn
I − R = NPV = V0 + F0 , one finds R = −V0 + t=1 Ft . Therefore,

−V0 + F − F0
ρ̄ = . (29)
C
In other words, computation of ρ̄ only requires the computation of the first economic value. In
Pn
principle, ρ̄ may even be expressed in terms of cash flows only. From V0 = t=1 Ft dt,0 ,
Pn
Ft (1 − dt,0 )
ρ̄ = t=1 . (30)
C
Or, using incomes and change in book values,
P 
n Pn
I
t=0 t (1 − dt,0 ) + t=0 ∆C d
t t,0
ρ̄ = . (31)
C
♦
capital borrowed, C d , is sufficiently low. In some situations, the (nonzero) difference between id and rd may reveal a
debt overhang problem (see Berk and DeMarzo 2014, pp. 554-555, and Myers 1977). The interest rate on debt may also
differ from the required return on debt whenever the the analysis of the project is made not when the firm raises the
debt capital but, rather, at a later stage. In this case, the firm may be using debt on which it is paying an interest rate
id which differs from the normal return on debt rd .
10
If fair-value accounting is employed, then ı̄ = I/V and the cost of capital becomes ρ̄ = r̄.

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 In light of what we have seen, the economic RI enables reconciling accounting data and economic
values in an intuitive and simple way, providing, as a byproduct, a natural reconciliation between
accounting rates and economic rates of return (where “economic” here means “determined by a
normal market where risk may be hedged by existing securities”). Extension to more than two
projects and more than two sources of financing is straightforward.

The approach presented differentiates itself from the traditional viewpoints found in the finance
literature for the following reasons:
(i) in the traditional approach to RI, the capital charges employ book values, which brings about
non-additivity and ambiguities for COCs as well as RIs
(ii) reconciliation of the standard RI with NPV is necessarily made via discounting, whereas the
economic RI does not require it
(iii) in the past literature, some averages of accounting rates have been investigated; however, the
averages proposed are not internal, for they all depend on some market rate (e.g. see Kay
1976, Peasnell 1981, 1982a,b, Edwards, Kay, and Mayer 1987, Ohlson 1995, Brief and Peasnell
1996, O’Hanlon and Peasnell 2002, Penman 2010, Magni 2010)11
(iv) we provide a decomposition of the NPV into a scale effect (total capital invested) and a
financial efficiency effect and a decomposition of the NPV in terms of investment policy and
borrowing policy, so that it becomes clear whether the locus of value creation lies in the
firm’s investment skills or in the firm’s borrowing skills and, for each such area, whether the
magnitude of the value created is due to a large scale of the investments or a high financial
efficiency. The decomposition of the NPV into scale and financial efficiency has been provided
by Hazen (2003) and Magni (2010) as well. However, in both cases, the scales are not internal,
that is, they depend on market rates via discounting and, as such, they are not additive (see
(27) above).12

5 Examples
Example 1 - Part I - Time-varying WACC. A firm is incorporated at time 0. Its operating
assets consist of two 3-period projects, labeled A and B. The two projects are assumed to have
different risk, and, therefore, they have different costs of capital. The investments are partially
covered with debt capital (i.e., the firm is levered), at an interest rate equal to id = 4%. The table
below reports the key assumptions on the firm:
11
See Feenstra and Wang (2000) for a summary about accounting rates of return.
12
Magni’s (2010) approach to rates of return is associated with the standard RI.

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 Key assumptions
Time (t) 0 1 2 3

Project A’s book values (C~ A) 200 70 0 0

Project A’s after-tax operating income13 −50 150 125
Project B’s book values (C~ B) 300 130 80 0
Project B’s after-tax operating income 250 −50 −75

Required return on project A (rA ) 8% (constant)

Required return on project B (rB ) 30% (constant)
Initial debt financing (book value) (C0d /C0 ) 40% (constant)
Amortization schedule ∆Ctd = −C0d /3
Interest rate on debt (id ) 4% (constant)
Required return on debt (rd ) 1% (constant)

The project’s cash flows are easily computed as Ftj = Itj − ∆Ctj , j = A, B, The cash flow to equity
is calculated as

Fte = FtA + FtB − Ftd

= (ItA + ItB ) − (∆CtA + ∆CtB ) − Ftd
= (ItA + ItB ) − (∆CtA + ∆CtB ) − 0.04 · Ct−1
d
+ C0d /3
| {z } | {z }
interest payment principal repayments

(see Table 3).

Table 3: Cash flows

t FtA FtB Ftd Fte
0 −200 −300 −196.7 −303.3
1 80.0 420 74.7 425.3
2 220.0 0 72.0 148.0
3 125.0 5.0 69.3 60.7

The economic values and the economic rates of return are described in Table 4. The economic values
of A and B are computed by discounting the respective cash flows at the respective risk-adjusted
cost of capital: Vtj = (Vt+1
j j
+ Ft+1 j
)/(1 + rt+1 ), j = A, B. Summing these values, the firm’s value is
obtained at each date, whence the WACC is calculated, denoted as rt . Subtracting the economic
value of debt, the economic value of equity is found. Therefore, Vte = VtA + VtB − Vtd . Hence, the
(time-varying) required return on levered equity is obtained: rte = (Vte − Vt−1 e
+ Fte )/Vt−1
e
.14 Note
that, although the input COCs (rA , rB , rd ) are time-invariant, the WACC and the cost of equity
capital (rt and rte ) are time-varying. Figures 1-4 fully describe the firm in terms of value created,
residual income, rates of return, and economic profitability.
Figure 1 uses the data found in Table 4 to illustrate the two different scenarios: On one hand, the
scenario with six expected cash-flow streams generated by investing in the firm; on the other hand,
13
After-tax operating income is equal to EBIT less taxes on net income (see Example 2 for a direct derivation of it.)
14
For example, r1e = (174.58 − 475.47 + 425.3)/475.47 = 0.2617.

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 Table 4: Economic values and costs of capital
t VtA VtB Vt rt Vtd Vte rte
0 361.92 325.35 687.27 211.80 475.47
1 310.87 2.96 313.83 18.41% 139.25 174.58 26.17%
2 115.74 3.85 119.59 8.21% 68.65 50.94 13.96%
3 0.00 0.00 0.00 8.71% 0.00 0.00 19.09%
SUM 788.53 332.16 1,120.69 419.70 700.98

the benchmark scenario with the same cash-flow streams generated by equivalent-risk replicating
portfolios. Specifically, the firm is described in terms of investments (A and B) and in terms of
financings (debt and equity), and in terms of the three basic elements: Invested capital, income,
and cash flow. To each of the four assets considered there corresponds a replicating portfolio, which
replicates the prospective cash flow stream of the corresponding asset. Note that C A + C B = C =
C e + C d = 780 and, likewise, V A + V B = V = V e + V d = 1, 120.7. The same holds for the incomes:
I A +I B = I = I e +I d = 350 and RA +RB = R = Re +Rd = 162.7. The same holds for cash flows as
well, which, in overall terms, are equal to the incomes: F A +F B = F = F e +F d = 350 = I. Figure 2
shows the economic RIs in the various perspectives; in particular, it presents the residual operating
incomes of the two projects, the firm’s residual operating income, the residual earnings, and the
residual financial expense. They all balance out, both at a period level and at an aggregate level.
Figure 3 shows nine double-entry tables which testify to the perfect decomposition provided by the
economic RI approach, in terms of income, capital charge, residual income, book value, accounting
rate, cost of capital, cash flow, economic efficiency, net present value. The average ROI generated
by the investments is equal to the average return to capital providers: ῑA+B = ῑe+d = 44.87% = ı̄,
and it may be viewed either as the book-value weighted mean of the rates of return of projects A
and B or as the book-value weighted mean of the average ROE and the average ROD:
average ROI of A average ROI of B firm’s ROE firm’s ROD
z }| { 270 z }| { 510 z }| { 380 z}|{ 400
83.33% · + 24.51% · = |44.87% = 87.89% · + 4% · .
780 780 {z } 780 780
ı̄

Likewise, the required return on the firm’s investments, ρ̄A+B , is equal to the required return to
equity and debt, ρ̄e+d , and may be viewed as the economic-value-weighted mean of the required
return to A and B, ρ̄A and ρ̄B , or, equivalently, to the economic-value-weighted mean of the required
return to equity and debt, ρ̄e and ρ̄d :
COC of A COC of B equity COC debt COC
z }| { 270 z }| { 510 z }| { 380 z }| { 400
23.36% · + 19.54% · = |20.86% = 41.72% · + 1.05% · .
780 780 {z } 780 780
ρ̄

Shareholder value creation is equal to NPVe = 1.75.47. It is the result of a favorable investment
policy and an inefficient financing policy. Specifically, both projects create value and the firm’s
NPV is NPV = 187.27. However, 1.1.8 out of this value is lost to debtholders (NPVd = 11.8),
owing to an inefficient borrowing policy.15 Most part of the NPV is generated by project A:
15
This is caused by a required return on debt, rd = 1%, which falls short of the interest rate on debt, id = 4%. See
footnote 9.

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 Notwithstanding the smaller scale (C A = 270 < 510 = C B ), the economic profitability of A is
59.97% (= 83.33% − 23.36%), much higher than the economic profitability of B, which is only
4.97%. The inefficiency of the debt policy is small (2.95% = 4% − 1.05%), but it is applied to
a nonnegligible capital base of 4.00, which results in the above mentioned loss of 1.1.8. Overall,
the equityholders invest a total 3.80 = 2.70 + 5.10 − 4.00 at a 46.18% excess return, generated by
an average ROE of 87.89%, net of a required return on equity equal to 41.72%. Figure 4 shows
that the standard RI does not provide an unambiguous information set. Owing to non-additivity,
three different, inconsistent sets of RIs are provided. Rates of return from standard RI may well
be carved out, but the rates will not balance out; nor will the scales be consistent (we do not dwell
on these rates of returns reasons of space. See Magni 2020 for details).

Example 1 - Part II - Time-invariant WACC. We now reconsider the above example but
change some assumptions. First, we assume that the debt-to-value ratio is pre-fixed, constant, and
equal to ϑ = 30%. Then, we assume that the firm’s cost of equity is exogenously given and equal
to re = 21%, while keeping the assumption of a cost of debt equal to rd = 1%. This implies that
the WACC is constant and equal to r = 0.3 · 0.01 + 0.7 · 0.21 = 0.15. Therefore, by discounting
the firm’s prospective cash flows F1 = 500, F2 = 220, and F3 = 130 at 15%, the firm’s economic
values are V~ = (686.6, 289.6, 113, 0), whence the debt values are V ~ d = 0.3 · V
~ = (206, 86.9, 33.9, 0).
Using Ft = Vt−1 (1 + rt ) − Vt for t > 0, one gets the prospective cash flows to debt: F1d = 121.2,
d d d d

F2d = 53.8, F3d = 34.3. Keeping the assumption id = 4%, the amount initially borrowed (initial
book value of debt) differs from the economic value of debt: C0d = 121.2/1.04 + 53.8/1.042 +
34.3/1.043 = 196.7 = −F0d . The remaining book values of debt are found by recursive application
of Ctd = Ct−1d
(1 + 0.04) − Ftd , so that C ~ d = (196.7, 83.4, 32.9, 0). The resulting cash flows to
equity and book values of equity are, respectively, F~ e = F~ − F~ d = (−303.3, 378.8, 166.2, 95.7)
and C ~e = C ~ −C ~ d = (303.3, 116.6, 47.1, 0). Using these data, the non-additivity of the standard
RI is easily established. For example, considering t = 1, the firm’s RI is RI1 = I1 − rC0 =
200 − 0.15 · 500 = 125 while the sum of the residual earnings and the residual financial expense is
RIe1 + RId1 = (192.1 − 0.21 · 303.3) + (7.9 − 0.01 · 196.7) = 134.3 6= 125. No such problems arise with
the economic RI.16

Example 2 (Explicit after-tax analysis). In the previous examples taxes are implicitly incor-
porated in the firm’s income, It , defined as pre-tax income less taxes on net income. We now show
a simple example where taxes are derived explicitly from the pre-tax operating income. Table 5
reports the inputs for a firm, partially financed with debt (bullet bond). EBIT (Earnings Before
Interest and Taxes) denotes the estimated pre-tax operating income. Subtracting the financial
expenses Itd from the EBIT, one gets the Earning Before Taxes (EBT). Applying the tax rate to
the EBT one finds the taxes, Tt . Subtracting them from EBT one gets the net income, Ite . Adding
back the financial expenses, one gets firm’s income, It .17 Subtracting the change in invested capital
from the firm’s income, one gets the firm’s cash flow. Hence, subtracting the cash flow to debt, one
derives the cash flow to equity (see Table 6).
The equity cash flow, Fte , and the debt’s cash flow, Ftd , are discounted at re and rd , respectively,
to find the economic values of equity and debt. This determines the firm’s economic value (Vt =
Vte +Vtd ) and the firm’s WACC, rte+d , which turns out to be time-varying (because the debt-to-value
ratio is time-varying) (see Table 7). The benchmark profits for the standard RI are calculated as
16
Data and computations are available on request.
17
Note that Ite + Itd = It = EBITt − Tt .

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 Table 5: Inputs for a levered firm
t 0 1 2 3
Tax rate 25%
EBIT 200 200 200
C 1000 700 500 0
Cd 400 400 400 0
id 4%
re 10%
rd 3%

Table 6: Unraveling the cash flows from the pro forma accounting magnitudes
t 0 1 2 3
Pre-tax income EBIT 200 200 200
Less: Financial expenses −I d −16 −16 −16
Earnings Before Taxes = EBT 184 184 184
Less: Taxes −T −46 −46 −46
Net Income = Ie 138 138 138
Plus: Financial expenses +I d 16 16 16
Firm’s income =I 154 154 154
Less: Change in capital −∆C −1000 300 200 500
Firm’s cash flow =F −1000 454 354 654
Less: Cash flow to debt −F d 400 −16 −16 −416
Cash flow to equity = Fe −600 438 338 238

rt Ct−1 , rte Ct−1

e d
, rtd Ct−1 . The stream of such profits is (60, 30, 10) for the equity, (12, 12, 12) for the
debt, and (77.3, 48.1, 27.2) for the firm. They are subtracted from the respective incomes Ite , Itd ,
It , t = 1, 2, 3, to get the residual incomes. As we expect, the standard RIs do not enjoy additivity:

78 + 4 = 82 6= 76.71 108 + 4 = 112 6= 105.91 128 + 4 = 132 6= 126.79

whereas additivity is preserved by the ERI:

52.37 + 3.66 = 56.03 87.60 + 3.77 = 91.37 116.36 + 3.88 = 120.25.18

(See Table 8.)

18
A rounding error occurs in the third equality (more precisely, 116.364 + 3.883 = 120.247.)

18

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 Table 7: Values and WACC
t 0 1 2 3
Ve 856.33 503.97 216.36 0
Vd 411.31 407.65 403.88 0
V 1267.65 911.62 620.25 0
re+d (WACC) 7.73% 6.87% 5.44%

Table 8: Standard and economic RI

t 0 1 2 3
RIe 78.00 108.00 128.00
RId 4.00 4.00 4.00
RIe + RId 82.00 112.00 132.00
RIe+d 76.71 105.91 126.79

ERIe 52.37 87.60 116.36

ERId 3.66 3.77 3.88
ERIe + ERId 56.03 91.37 120.25
ERIe+d 56.03 91.37 120.25

6 Necessary and sufficient conditions for an additive RI

This section illustrates the conditions under which the standard RI is additive. A sufficient condition
for additivity of the standard RI is Cth = Vth and Ctk = Vtk for all t (investment perspective) as well
as Cte = Vte and Ctd = Vtd for all t (financing perspective). This means that all book values equate
economic values. However, in this case, the book rates of return equate the market rates of return
(ih = rh , ik = rk , ie = re , id = rd ), all the RIs are zero, all the NPVs are zero, and additivity just
means 0 + 0 = 0 under both investment and financing perspectives:

RIht + RIkt = Ith − rh Ct−1

h
+ Itk − rk Ct−1
k

= (iht − rth )Ct−1

h
+ (ikt − rtk )Ct−1
k
=0+0

and

RIh+k
t = Ith+k − rh+k Ct−1
h+k

rth Vt−1
h
+ rtk Vt−1
k
= Ith+k − h +Vk
h
· (Ct−1 k
+ Ct−1 )
Vt−1 t−1
rth Ct−1
h
+ rtk Ct−1
k
= Ith+k − h k
h
· (Ct−1 k
+ Ct−1 )
Ct−1 + Ct−1
= Ith+k − (iht Ct−1
h
+ ikt Ct−1
k
)=0

(same result under the financing perspective, with e and d replacing h and k). Therefore, in this
case, additivity of the RIs is pointless.

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 More generally, inspecting eqs. (7)-(8), the necessary and sufficient conditions for additivity to
hold are
(h+k)∗
rth+k = rt for all t (32)
(e+d)∗
rte+d = rt for all t (33)

where
rth Vt−1
h
+ rtk Vt−1
k
rth+k = h k
Vt−1 + Vt−1
(h+k)∗ rth Ct−1
h
+ rtk Ct−1
k
rt = h k
Ct−1 + Ct−1
rte Vt−1
e
+ rtd Vt−1
d
rte+d = e +Vd
Vt−1 t−1

(e+d)∗ rte Ct−1

e
+ rtd Ct−1
d
rt = d d
.
Ct−1 + Ct−1

Manipulating algebraically, these conditions boil down to

k (h+k)∗
Vt−1 rt − rh
h
= (h+k)∗
(34)
Vt−1 rk − rt
d (e+d)∗
Vt−1 rt − re
e = (e+d)∗
. (35)
Vt−1 rd − rt

This means that the ratio of the (beginning-of-period) economic values of the two projects must be
equal to a ratio which is a function of
(1) the required return on project h,
(2) the required return on project k, and
(3) the book-value weighted mean of (1) and (2),
and the ratio of the (beginning-of-period) economic values of equity and debt must be equal to a
ratio which is a function of
(1) the cost of equity
(2) the cost of debt, and
(3) the book-value weighted mean of (1) and (2).
Unfortunately, this situation is by no means a realistic assumption and it may only occur by mere
happenstance.

Example 3 - Additivity of standard RI. Equations (34)-(35) set the conditions under which
the standard RI is additive. For reasons of space, we only focus on the investment perspective.
Table 9 reports the inputs of two projects which fulfills condition (34).
The project’s cash flows are derived as usual from

Ftj = Itj − ∆Ctj

for j = h, k, h + k. Discounting cash flows at rh and rk the economic values are obtained. Using
these rates and the previously computed values, the weighted means rh+k and r(h+k)∗ are derived

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 Table 9: Inputs for an additive RI
t 0 1 2 3
Ih 30 20 9
Ik 20 15 12
Ch 300 200 100 0
Ck 250 180 130 0
rh 8% 8% 8%
rk 6.18% 6.57% 8.23%

Table 10: Cash flow, values, and rates

t 0 1 2 3
Fh −300 130 120 109
Fk −250 90 65 142
Vh 309.779 204.5615 100.926 0
Vk 258.149 184.105 131.204 0

r(h+k)∗ 7.173% 7.323% 8.129%

rh+k 7.173% 7.323% 8.129%
r(h+k)∗ − rk
0.833 0.900 1.300
rh − r(h+k)∗
Vk
0.833 0.900 1.300
Vh

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 Table 11: Residual incomes
t 0 1 2 3
RIh 6.000 4.000 1.000
RIk 4.548 3.171 1.303
RIh + RIk 10.548 7.171 2.303
RIk+h 10.548 7.171 2.303

ERIh 5.218 3.635 0.926

ERIk 4.044 2.901 1.204
ERIh + ERIk 9.262 6.536 2.130
ERIh+k 9.262 6.536 2.130

NPVh 9.779
NPVk 8.149
NPVh + NPVk 17.928
NPVh+k 17.928

(see Table 10). Finally, Table 11 reports the standard residual incomes and economic residual
incomes, respectively. Both RIs and ERIs are additive. However, note that RI and ERI are not
equal. This is quite natural, for the traditional RI approach is reconciled with NPV only if the
RIs are discounted. In contrast, the ERI approach provides the NPV by merely summing the
(undiscounted) ERIs (Table 11 reports all the NPVs).

7 Concluding remarks
The residual income (RI) notion is not additive. This implies that, theoretically, this concept
is inadequate for financial and managerial purposes. We propose a different approach to residual
income which overcomes the biases of the standard RI. It is based on economic values and economic
rates of return. Specifically, the capital charge is equal to the profit investors would earn if they
invested in a financial asset, traded in a normal market, equivalent in risk to the project and
generating the same prospective cash flows as the project’s. We call the new measure economic RI.
The economic RI is unambiguous and is invariant under changes in the description of the project
or firm. It allows segment RIs to be calculated in a consistent way; in particular, it is the same
whether it is calculated from the investment side or from the financing side, because the residual
operating income, the residual earnings, and the net financial expense always balance out. For this
reason, it enables carrying out detailed and reliable analyses of efficiencies precisely measuring the
locus of efficiency and the contributions of the various areas. The internal average ROI (and ROE)
presented in Magni (2020, 2021) stem naturally from the economic approach and enables reframing
the NPV into a scale component and a financial-efficiency component.

22

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 PROJECT A PROJECT B INVESTMENT A + B
(1) (2) (3) (4) (5) (6) (7) (8) (1)+(5) (2)+(6) (3)+(7) (4)+(8)
t

0 0.0 0.0 -200.0 200.0 0.0 0.0 -300.0 300.0 0.0 0.0 -500.0 500.0
1 200.0 -50.0 80.0 70.0 300.0 250.0 420.0 130.0 500.0 200.0 500.0 200.0
2 70.0 150.0 220.0 0.0 130.0 -50.0 0.0 80.0 200.0 100.0 220.0 80.0
3 0.0 125.0 125.0 0.0 80.0 -75.0 5.0 0.0 80.0 50.0 130.0 0.0
SUM 270.0 225.0 225.0 270.0 510.0 125.0 125.0 510.0 780.0 350.0 350.0 780.0

DEBT EQUITY FINANCING D + E

(9) (10) (11) (12) (13) (14) (15) (16) (9)+(13) (10)+(14) (11)+(15) (12)+(16)
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0 0.0 -200.0 200.0 0.0 0.0 -300.0 300.0 0.0 0.0 -500.0 500.0
1 200.0 8.0 74.7 133.3 300.0 192.0 425.3 66.7 500.0 200.0 500.0 200.0
2 133.3 5.3 72.0 66.7 66.7 94.7 148.0 13.3 200.0 100.0 220.0 80.0
3 66.7 2.7 69.3 0.0 13.3 47.3 60.7 0.0 80.0 50.0 130.0 0.0
SUM 400.0 16.0 16.0 400.0 380.0 334.0 334.0 380.0 780.0 350.0 350.0 780.0

REPLICATING PORTFOLIO A REPLICATING PORTFOLIO B REPLICATING PORTFOLIO A+B

(1) (2) (3) (4) (5) (6) (7) (8) (1)+(5) (2)+(6) (3)+(7) (4)+(8)
t

0 0.0 0.0 -361.9 361.9 0.0 0.0 -325.4 325.4 0.0 0.0 -687.3 687.3
1 361.9 29.0 80.0 310.9 325.4 97.6 420.0 3.0 687.3 126.6 500.0 313.8
2 310.9 24.9 220.0 115.7 3.0 0.9 0.0 3.8 313.8 25.8 220.0 119.6
3 115.7 9.3 125.0 0.0 3.8 1.2 5.0 0.0 119.6 10.4 130.0 0.0
SUM 788.5 63.1 63.1 788.5 332.2 99.6 99.6 332.2 1,120.7 162.7 162.7 1,120.7

REPLICATING PORTFOLIO D REPLICATING PORTFOLIO E REPLICATING PORTFOLIO D+E

(9) (10) (11) (12) (13) (14) (15) (16) (9)+(13) (10)+(14) (11)+(15) (12)+(16)
t

0 0.0 0.0 -211.8 211.8 0.0 0.0 -475.5 475.5 0.0 0.0 -687.3 687.3
1 211.8 2.1 74.7 139.3 475.5 124.4 425.3 174.6 687.3 126.6 500.0 313.8
2 139.3 1.4 72.0 68.6 174.6 24.4 148.0 50.9 313.8 25.8 220.0 119.6
3 68.6 0.7 69.3 0.0 50.9 9.7 60.7 0.0 119.6 10.4 130.0 0.0
SUM 419.7 4.2 4.2 419.7 701.0 158.5 158.5 701.0 1,120.7 162.7 162.7 1,120.7

Figure 1: Firm’s investments and financings and associated portfolios replicating the project’s prospective cash flows. Additivity holds
for both firm and replicating portfolio. Note that the market value of portfolio A+B is equal to the sum of the market value of portfolio
D+E. Likewise, the economic return of A+B is equal to the sum of the economic returns of D+E. The value and the corresponding
economic returns are unambiguous.
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PROJECT A PROJECT B INVESTMENT SIDE

(1) (2) (3) (4) (5) (6) (1)+(4) (2)+(5) (3)+(6)
t

1 -50.0 29.0 -79.0 250.0 97.6 152.4 200.0 126.6 73.4

2 150.0 24.9 125.1 -50.0 0.9 -50.9 100.0 25.8 74.2
3 125.0 9.3 115.7 -75.0 1.2 -76.2 50.0 10.4 39.6
SUM 225.0 63.1 161.9 125.0 99.6 25.4 350.0 162.7 187.3

DEBT EQUITY FINANCING SIDE

(7) (8) (9) (10) (11) (12) (7)+(10) (8)+(11) (9)+(12)
t

1 8.0 2.1 5.9 192.0 124.4 67.6 200.0 126.6 73.4

2 5.3 1.4 3.9 94.7 24.4 70.3 100.0 25.8 74.2
3 2.7 0.7 2.0 47.3 9.7 37.6 50.0 10.4 39.6
SUM 16.0 4.2 11.8 334.0 158.5 175.5 350.0 162.7 187.3

Figure 2: Economic RIs. Given unambiguous capital charges, economic RI is unambiguous: Economic RI of investments is equal to
economic RI of financings.
 (1) (2) (3) = (1) ̶ (2)
Capital charges
Incomes Residual incomes
(Economic returns)
Investment Financing Investment Financing Investment Financing
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Project A 225 334 Equity Project A 63.08 158.53 Equity Project A 161.92 175.47 Equity
Project B 125 16 Debt Project B 99.65 4.20 Debt Project B 25.35 11.80 Debt
350 350 162.73 162.73 187.27 187.27

(4) (5) = (1) : (4) (6) = (2) : (4)

Book values Accounting rates Costs of capital

Investment Financing Investment Financing Investment Financing
Project A 270 380 Equity Project A 83.33% 87.89% Equity Project A 23.36% 41.72% Equity
Project B 510 400 Debt Project B 24.51% 4.00% Debt Project B 19.54% 1.05% Debt
780 780 44.87% 44.87% 20.86% 20.86%

(7) = (1) (8) = (5) ̶ (6) (9) = (4) x (8) = (3)

Economic
Cash flows NPVs
efficiencies
Investment Financing Investment Financing Investment Financing
Project A 225 334 Equity Project A 59.97% 46.18% Equity Project A 161.92 175.47 Equity
Project B 125 16 Debt Project B 4.97% 2.95% Debt Project B 25.35 11.80 Debt
350 350 24.01% 24.01% 187.27 187.27

Figure 3: Economic RI and efficiency analysis (aggregate analysis). Monetary amounts balance by summing them up; rates of return
(and economic efficiencies) balance by weighting them up with the respective associated values.
 PROJECT A PROJECT B INVESTMENT RI
(1) (2) (3) (4) (5) (6) (1)+(4) (2)+(5) (3)+(6)

t + +

1 -50.0 16.0 -66.0 250.0 90.0 160.0 200.0 106.0 94.0

2 150.0 5.6 144.4 -50.0 39.0 -89.0 100.0 44.6 55.4
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3 125.0 0.0 125.0 -75.0 24.0 -99.0 50.0 24.0 26.0

SUM 225.0 21.6 203.4 125.0 153.0 -28.0 350.0 174.6 175.4

DEBT EQUITY FINANCING RI

(7) (8) (9) (10) (11) (12) (7)+(10) (8)+(11) (9)+(12)

t + +

1 8.0 2.0 6.0 192.0 78.5 113.5 200.0 80.5 119.5

2 5.3 1.3 4.0 94.7 9.3 85.4 100.0 10.6 89.4
3 2.7 0.7 2.0 47.3 2.5 44.8 50.0 3.2 46.8
SUM 16.0 4.0 12.0 334.0 90.4 243.6 350.0 94.4 255.6

PROJECT RI
t
1 200.0 92.1 107.9
2 100.0 16.4 83.6
3 50.0 7.0 43.0
SUM 350.0 115.5 234.5

Figure 4: Standard RIs. The standard RI notion brings about different values in each period: the RI of the asset side is different from the
RI of the financing side. In addition, the project RI, calculated subtracting the capital charge rt Ct−1 from the overall income It = ItA +ItB ,
is different from the previous two. Furthermore, in aggregate terms, the standard RI generates three different standard RIs: 175.4, 255.6,
234.5.
 Acronyms
COC cost of capital, required return
EBIT Earnings Before Interest and Taxes
NPV net present value
RI residual income
ERI economic RI
ROE return on equity
ROD return on debt
ROI return on investment
WACC weighted average cost of capital
Symbols
∆ variation
ρ̄ overall cost of capital
Ct book value, capital
dt,0 discount factor
Ft cash flow generated by the firm (project)
Ft∗ cash flow generated by the portfolio replicating book values
(standard RI approach)
It income
Ite net income
Itd financial expenses
it accounting rate of return
ı̄ average ROI
Rt economic return
rt required return, expected return on
the benchmark portfolio
rtj required return on j, j = h, k, e, d
rtj+l WACC (value-weighted mean of rj and rl ), j = h, k, e, d
(j+l)∗
rt book-value weighted mean of rj and rl , j = h, k, e, d
Vt economic value, market value
Superscripts
d debt
e equity
f financial
o operating
h project h
k project k

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