Residual income helps assess how profitable a company is after the minimum required rate of return. Therefore, if a company is earning more than it needs to based on its assets, then it has residual income and is considered to be a good investment. There are two major methods to calculate the residual income, both of which yield the same result.
With Equity Charge
The residual income can be calculated with the net operating income minus the equity charge, which is a way to determine how much income the equity should be earning each year. Calculate the equity charge by multiplying the total value of the equity by the percent that they should be earning in net income each year. The company usually sets this percent. Subtract the result from the actual net operating income to get the residual income.
Equity Charge Example
Say a company has $300,000 in operating equity. The company has promised shareholders a rate of return of 15 percent each year. The company earned a net income last year of $62,134. Using these numbers, calculate the equity charge by multiplying $300,000 times 0.15 to get a required income of $45,000. Calculate $62,134 minus $45,000 to get a residual income of $17,134.
With Cost of Capital
The second method for calculating the residual income uses the cost of capital and the after-tax operating income. To calculate the cost of capital, multiply the percent of the assets that are equity times the cost of equity and add the percent of assets that are debt times the cost of debt times the percent of the income that does not go to taxes. The result is the weighted average cost of capital (WACC). Calculate the residual income by multiplying the total amount of assets (including both debt and equity) and the WACC and subtracting the result from the after-tax operating income.
Cost of Capital Example
Say the company has $200,000 in equity at a cost of 10 percent and $100,000 in debt at a cost of 8 percent. This makes total assets of $300,000. The company pays 35 percent of its income in taxes. The WACC is 0.1($200,000/$300,000) + 0.08($100,000/$300,000)(0.65), which is 0.084. Multiply 0.084 times $300,000 to get $25,200. Subtract this from the company's after-tax income of $42,334 to get a residual income of $17,134.