What is Residual Income?
Residual Income measures the excess net operating income earned over the required rate of return on a company’s operating assets.
Table of Contents
- How to Calculate Residual Income (Step-by-Step)
- Residual Income Formula
- How to Interpret Residual Income in Corporate Finance
- Capital Budgeting Rules: “Accept” or “Reject” Project
- Residual Income Calculator – Excel Model Template
- Step 1. Project Income and Operating Assets Assumptions
- Step 2. Project Residual Income Calculation Analysis
How to Calculate Residual Income (Step-by-Step)
In corporate finance, the term “residual income” is defined as the operating income generated by a project or investment in excess of the minimum required rate of return.
The metric is used by companies to help determine whether to pursue certain projects or not.
The first step in estimating the residual income is calculating the product of the minimum required rate of return and the average operating assets.
The minimum required rate of return is conceptually the same as the cost of capital, i.e. the expected return given the risk profile of the project or investment in question.
The minimum return can differ based on the department or division undertaking the project – or be separately estimated based on the operating assets – but the company’s cost of capital can also be used, as it is usually sufficient for general capital budgeting purposes.
From there, the product of the minimum required rate of return and average operating assets is subtracted from the project’s operating income.
Residual Income Formula
The formula for calculating the residual income is as follows.
The product of the minimum required rate of return and average operating assets represents the minimum target return, i.e. the “desired income”.
How to Interpret Residual Income in Corporate Finance
Capital Budgeting Rules: “Accept” or “Reject” Project
For purposes of decision-making under the context of capital budgeting, the general rule is to accept a project if the implied residual income is greater than zero.
- If Residual Income > 0 → Accept Project
- If Residual Income < 0 → Reject Project
The generalized rule in capital budgeting states that in order for a company to maximize its firm value, only projects that earn more than the company’s cost of capital should be pursued.
Otherwise, the project will reduce the value of the company, rather than create value.
By estimating the residual income before taking on projects, companies can allocate their capital on hand more efficiently to ensure that the return (or potential return) is worth the trade-off in terms of risk.
- Positive RI → Exceeds Minimum Rate of Return
- Negative RI → Lower than Minimum Rate of Return
Of course, the metric will not dictate corporate decisions on its own, but projects with positive residual income are more likely to be accepted internally because of the increased economic incentive.
Residual Income Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. Project Income and Operating Assets Assumptions
Suppose a company is attempting to decide whether to pursue a project or pass on the opportunity.
The project is projected to generate $125k in operating income in Year 1.
The value of the operating assets at the beginning of the period (Year 0) was $200k while the value was $250k at the end of the period (Year 1).
- Beginning Operating Assets = $200k
- Ending Operating Assets = $250k
By adding those two figures and dividing them by two, the average operating assets equal $225k.
- Average Operating Assets = $225k
Step 2. Project Residual Income Calculation Analysis
If we assume the minimum required rate of return is 20%, what is the project’s residual income?
To determine the project’s residual income, we’ll start by multiplying the minimum required rate of return (20%) by the average operating assets ($225k).
As mentioned earlier, the resulting amount – $45k in our example – represents the target (desired) income from the project.
The more excess income there is above the target (desired) income, the more profitable the project is.
The final step is to subtract the target (desired) income amount from the project’s operating income ($125k).
The resulting figure is $80k, which represents the project’s residual income. Because this figure is positive, it suggests the project should likely be approved.
- Residual Income = $125k – (20% × $225k) = $80k