Residual income
Taught by Nick Drape · AI tutor support included
You'll learn how residual income works as a performance measure for investment centres, and why it's fundamentally different from return on investment.
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In this lesson
- 0:00 Residual income: absolute measure explained
- 0:22 Calculating residual income formula
- 1:02 Positive versus negative residual income
- 1:36 Operating profit and capital invested components
- 2:30 Goal congruence and divisional alignment
- 3:06 Merits of residual income approach
- 4:21 Drawbacks and practical limitations
About this lesson
Residual income calculates an absolute figure (in pounds or dollars) by taking a division's operating profit and deducting a notional interest charge based on capital invested multiplied by the company-wide cost of capital. This approach eliminates dysfunctional decision-making because it aligns divisional managers' goals with overall company objectives, ensuring managers focus on generating returns that exceed the capital providers' requirements. You'll also explore the key advantages—such as highlighting the true cost of finance to managers—and the practical drawbacks, including difficulty comparing divisions of different sizes and challenges in determining an accurate cost of capital in real-world settings.
Duration: 5m
Transcript
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