Residual IncomeDefined with Examples
What is Residual Income?
Residual income is a type of income that can mean different things depending on the context.
There are three different types of residual income:
- Residual Income from Equity Valuation
- Corporate Finance
- Personal Finance
It is an income that a company continues to earn even when the cost of the investment has already been used, or the income still earned when all work has been completed.
It could also be the income after a firm pays all of their obligations and debts.
Other terms used for residual income are passive income when it refers to individuals or businesses.
Examples of residual income are stocks or bonds, royalties, investments in real estate, and other investment accounts.
How Residual Income Works
The computation of the residual income helps companies to make a better allocation of their resources in a manner that is more efficient and beneficial for the firm.
In theory, residual income is the amount left after taking all the cost of capital into consideration.
Types of Residual Income
The approximation of the intrinsic value of a firm’s shares is arrived at by computing for the Residual Income.
This amount is a result of the assessment of a company’s book value and the present value of the expected residual income.
Residual Income = Net Income – Equity Charge
Where: Equity Charge = Cost of Equity x Equity Capital
Based on the formula above, the Residual Income is the difference of the net income less all the cost of capital or opportunity costs attached to the sources of capital.
There are some cases when the result of the calculation of the Residual Income is a negative amount although the firm has made a positive net income.
The Residual Income as defined in terms of Corporate Finance is put simply, the leftover income after subtracting the cost of capital related to the operations needed to generate revenue.
It is also the amount in excess of the company’s rate of return.
RI = Operating Income – (Average of Operating Assets * Required Rate of Return)
Where: Operating Income = Revenue of a Project – Expenses
Average of Operating Assets = Resources required to sustain the operations of the company like cash, inventory, fixed assets, accounts receivable, etc.
Required Rate of Return = Minimum return that a company expects and is willing to accept from their investments
In terms of Personal Finance, a Residual Income is the amount that is left after a person pays for all of his or her debts.
It can also be referred to as Disposable Income, and is an important factor when someone tries to apply for a loan.
Lenders will look at the residual income of a person before they are granted the loan amount, and the higher the residual income of a person wishing to take a loan, the higher are his or her chances of securing one with a more favorable loan amount.
Example of Residual Income
Company ABC has made an investment in Company X in the amount of $500,000 and it is expected to generate a 10% annual rate of return from Company ABC’s investment.
For the year ended 2020, Company X made a net income of $83,000.
Based on the data provided above, the Return of Investment that Company ABC expects is $50,000 ($500,000 x 10%).
The Residual Income is therefore $33,000 ($83,000 – $50,000), which is the difference of the Net Income of Company X less the Return of Investment that Company ABC expects Company X to generate.
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University of Delaware "Residual Income Valuation: Valuing Common Equity" Chapter 8. January 4, 2022
Columbia Business School "What Matters in Company Valuation: Earnings, Residual Earnings, Dividends? Theory and Evidence" Page 1 . January 4, 2022
Montana State University "Residual Income" Page 1 - 2. January 4, 2022