Question

Write 500 words explaining residual income

Answer 1

Residual income is the amount of income that an individual has after all personal debts and expenses, including a mortgage, have been paid. This calculation is usually made on a monthly basis, after the monthly debts are paid. Additionally, residual income is used by a company's management team to measure the return generated above the company's minimum required return.

Since, residual income measures the amount of money that is left over after all required costs of capital have been paid for the period being analyzed, it is used in corporate and personal finance both.

a. Personal residual income: Also known as a person's disposable income. For example, if a person earns $10,000 a month at a 35% tax rate, his take-home earnings before factoring in debt or expenses would be $6,500. If he has a monthly mortgage payment of $1,000 and $1,000 in other expenses, his residual income would be $4,500. Then, when the mortgage has been paid off in its entirety, the $1,000 that he had been putting toward the mortgage also becomes part of residual income, making the new residual income number $5,500.

Residual income is therefore often an important component of securing a loan. A loaning institution usually assesses the amount of residual income an individual has left after paying off other debts each month. If the individual requesting the loan has sufficient residual income to take on additional debt, the loaning institution is more likely to grant the loan. Having an adequate amount of residual income will ensure that the borrower has sufficient funds to make the loan payment each month.

b. Residual Income for Corporate Finance: Managerial accounting defines residual income in a corporate setting as the amount of operating revenues left over after all costs of capital used to generate the revenues have been paid. It is also considered to be the company's net operating income, or the amount of profits that exceed its required rate of return. Residual income is normally used to assess the performance of a department or a business unit.

The calculation of residual income is as follows: Residual income = Net operating income - (cost of capital * cost of operating assets). This equation is essentially used as a measurement of opportunity cost, based on the trade-offs of investing in one department versus another department. The business unit that has a higher residual income gets more company investments.

c. Referring to the formula above, the residual income valuation formula is similar to the dividend discount model (DDM) (and to other discounted cash flow (DCF) valuation models), substituting future residual earnings for dividend (or free cash) payments (and the cost of equity for the weighted average cost of capital). However, the RI-based approach is most appropriate when a firm is not paying dividends or exhibits an unpredictable dividend pattern, and / or when it has negative free cash flow many years out, but is expected to generate positive cash flow at some point in the future.

It is thus possible that a value deemed positive using a traditional discounted cash flow (DCF) approach may be negative here. RI-based valuation is therefore a valuable complement to more traditional techniques.