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© 2012 Growing Science Ltd. All rights reserved.
doi: 10.5267/j.msl.2012.09.028
Management Science Letters 2 (2012) 2851–2856
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Management Science Letters
homepage: www.GrowingScience.com/msl
An investigation on relationship between residual income and internal and external
performance measures
Hesam Daryania* and Seyed Yousef Ahadi Serkanib
aM.A. Student, Department of Accounting, School of Management, Tehran North Branch, Islamic Azad University (IAU), Tehran, Iran
bAssist.Prof. & Faculty Member, Department of Accounting, Firoozkooh Branch, Islamic Azad University (IAU), Iran
A R T I C L E I N F O A B S T R A C T
Article history:
Received August 10, 2012
Accepted 28 September 2012
Available online
September 28 2012
During the past few years, there have been growing interest in learning the relationship between
residual income and other financial figures such as dividend per share, market value and
operating cash flow. The proposed study of this paper gathers the financial information of all
listed firms traded in Tehran Stock Exchange over the period of 2007-2011. We only
concentrate on listed companies whose fiscal years started from March to May of each year.
The other criterion associated with the proposed study of this paper is that shares of the selected
firms must have been active during period of study and there must be no change in their fiscal
calendar. The study does not include the shares of holdings, banks, insurance firms. Finally, the
information of the firms must be available for course of study. The study uses two regressions
analysis and examines five hypotheses including the relationship between residual income and
other factors including dividend per share, value added operating cash flow, value added cash
flow, market cap and market value added. Using two regression models, all these hypotheses
are investigated and the results of the survey confirm a meaningful relationship between
residual income and dividend per share, value added operating cash flow, value added cash
flow. However, the results of the second model do not confirm the last two hypotheses.
© 2012 Growin
g
Science Ltd. All ri
g
hts reserved.
Keywords:
Residual income
Operating cash flow
Tehran stock exchange
1. Introduction
During the past few years, there have been growing interests on learning more about the impact of
residual income on other financial figures such as operating cash flow, dividend per share, etc.
(Worthington & West, 2004; Reddy Irala, 2005). In fact, there are some evidences to believe that an
increase on residual income positively impact on overall market (Hall & Brummer, 1999). There are
also other related works associated with market behavior. Magni (2009), for instance, performed a
comprehensive investigation on capital budgeting decisions, sales and production and decisions, use
of optimal portfolios, prediction of asset prices and estimation of intrinsic values. Magni (2010), in
another assignment, performed an in depth investigation on residual income and value creation and
2852
proposed a new method for measuring residual income. Lin et al. (2011) tried to understand whether
stock prices of stock-financed acquirers could move in direction of their fundamental value in long
term and whether they could correct their initial overvaluation. Their results indicated that more
overvalued acquirers were related to weaker post-acquisition returns.
Athanasoulis and Shiller (2002) studied a new technique of decomposing the variance of national
incomes into components to determine the most influencing ‘residual’ risk-sharing opportunities
among peoples of the world. Keller and Siegrist (2006) studied the impact of financial risk behavior,
money achievement and negative ethical stance towards the stock market, income, and gender on
willingness to purchase stocks. They reported that income was a substantial positive predictor for
men with an investment account. In addition, money attitude budget was an important negative
predictor for men and women who do not maintain an investment account. On the contrary,
achievement had no substantial impact on willingness to invest in stocks.
Machuga et al. (2002) studied economic value added, future accounting earnings, and financial
analysts' earnings per share predictions. Pan et al. (2007) performed a comprehensive study on the
dynamic responses of stock prices to shocks measured by earnings and dividends. They decomposed
historical information of aggregate earnings, stock prices and dividend into permanent and transitory
components among three data series. They reported that approximately 95% of the variation in stock
returns could be described by permanent earnings and permanent dividends.
The proposed study of this paper gathers the financial information of all listed firms traded in Tehran
Stock Exchange over the period of 2007-2011. The organization of this paper first presents details of
our statement in section 2. Section 3 presents details of our findings and finally, concluding remarks
are given in the last to summarize results of the paper.
2. The proposed method
The proposed model of this paper considers the following five hypotheses,
1. There is a meaningful relationship between residual income and dividend per share.
2. There is a meaningful relationship between residual income and value added operating cash
flow.
3. There is a meaningful relationship between residual income and cash value added.
4. There is a meaningful relationship between residual income and market cap.
5. There is a meaningful relationship between residual income and market value added.
The proposed study of this paper gathers the financial information of all listed firms traded in Tehran
Stock Exchange over the period of 2007-2011. The proposed study only focused on listed companies
whose fiscal years started from March to May of each year. The other criterion associated with the
proposed study of this paper is that shares of the selected firms must have been active during period
of study and there must be no change in their fiscal calendar. The study did not include the shares of
holdings, banks, insurance firms. Finally, the information of the firms must be available for course of
study.
2.1 Variables
2.1.1 Residual income
Residual income is calculated as a difference between revenue, capital cost of equities, and it is
calculated as follows,
S. Y. Ahadi Serkani and h. Daryani / Manageme nt Science Letters 2 (2012)
2853
()
,,,,1
,
it it it it
RI NI r BV −
=−× (1)
where RIi,t is the residual income of firm i in year t, NIi,t is the net income of firm i in year t and it is
extracted from the firm's statement, BVi,t-1 is the book value of firm i in year t and finally
2.1.2. Cost of capital
Cost of capital, ri,t is cost of capital of firm i in year t and it is calculated as follows,
(2)
)()(
,,
,
,,
,
,titi
ti
titi
ti
ti SD
D
kd
SD
S
ker +
+
+
=
where Si,t is the average value of equities of firm i in year t, Di,t is average of all liabilities of firm i
in year t.
2.1.3. Cost of borrowing
Cost of borrowing (kd) of firm i in year t is calculated as follows
(3)
)1( TR
LTFSTFIC
kd −
+
=
where IC is the interest cost, STF is the short term financing, LTF is the long term financing and TR
is tax rate.
2.1.4. Cost of equity
Cost of equity (ke) of firm i in year t is calculated as follows, (4)
0
,
D
ke g
P
=+
where D is the dividend per share, P0 is share price before annual meeting and g is growth
rate calculated using geometric mean in a three-year period. Dividend per share (DPS) is
determined normally when the regular annual meeting is held and it is a portion of earning
per share (EPS). Operating cash flow is another important measure, which must be
accomplished in long term for the survival of the firm. Cash value added (CVA) represents
the created wealth in a fiscal year and in this paper we calculated as follows,
titititititi CFOTPSPIPDPCVA ,,,,,, ++++= , (5)
where CVAi,t is cash value added of firm i in year t, DPi,t is dividend per share of firm i in year t,
IPi,t is the cost of interest of firm i in year t, SPi,t is sum of equities of firm i in year t, TPi,t is paid
Tax of firm i in year t and finally, CFOi,t is operating cash flow of firm i in year t, respectively.
2.1.5. Market Value (MV)
Market value is calculated by multiplying the number of shares by market price at the end of each
fiscal year.
2854
2.1.6 Market Value Added (MVA)
Market value added is calculated as the difference between market value (MVi,t) and investment
capital (ICi,t) for firm i in year t as follows,
tititi ICMVMVA ,,, −= , (6)
and ICi,t is calculated as the sum of net book value of fixed assets ( ti
FA,) and working capital (
ti
WC,) for firm i in year t.
The proposed model of this paper considers the following two models for studying the behavior of
residual income as follows,
ittitititi CVAOCFDPSRI
ε
β
β
β
β
+
+++= ,3,2,10, (7)
ittititi MVAMVRI
ε
β
β
β
+++= ,2,10, (8)
Table 1 shows details of some statistical observations including the number of observations (N),
mean, standard deviation, min and max, skewness and string.
Table 1
Statistical observations of the input data
N Mean Std. dev. min max Skewness String
RI 864 864.64 1132.4 -6457.76 6953.06 1.237 7.810
DPS 864 797.26 941.29 0 7300 2.877 11.276
OCF 862 1030.63 1584.28 -4928.76 23315.56 4.969 52.111
CVA 862 3925.47 3764.99 207.17 53249.85 5.110 47.187
MV 864 7028.95 10110.94 535.00 92502.00 4.352 24.054
MVA 861 5426.34 10711.21 -2736.62 89871.92 4.199 21.594
Based on the results of Table 1, we realize that we can perform the regression analysis on both
models using panel data.
3. The results
The first three hypotheses of this survey are validated based on Eq. (1) using panel data and when all
three coefficients of 1
β
, 2
β
and 3
β
are statistically meaningful we can confirm all of them. The
results of Chaw test yield F-value of 1.487 with P-value of 0.0019 while Chi-Square value for Haman
test is 19.706 with P-value of 0.0002. These are preliminary results for validating the model when the
level of significance is 5%. In addition, we have performed Breusch-Pagan test where F-value is
calculated as 3.003 with P-value of 0.0292 and Durbin-Watson has been calculated as 2.04. These
statistical observations confirm the results.
,,,,
2
311.47 0.8070 0.1174 0.1115
t-student (-7.093) (20.542) (-4.286) (8.515) 0.7421 19.650 0.000
it it it it it
RI DPS OCF CVA
R F P value
ε
=− + − + +
==−=
(9)
As we can observe from the results of t-student value given in Eq. (9), all coefficients are statistically
meaningful when the level of significance is five percent. R-Square yields 0.7421, which means the
independent variables can describe approximately 74% of the changes in dependent variable. In
S. Y. Ahadi Serkani and h. Daryani / Manageme nt Science Letters 2 (2012)
2855
summary, we can conclude that an increase of one unit in dividend per share can increase residual
income by 0.8070 while an increase of one unit in operating cash flow will reduce residual income by
0.1174 and finally an increase of one unit in value added cash flow will increase residual income by
0.1115. F-value is statistically meaningful when the level of significance is 5% and this means there
is a linear relationship between independent and dependent variables.
Hypotheses five and six of this survey are validated based on Eq. (2) using panel data and when all
three coefficients 0
β
, 1
β
and 2
β
are statistically meaningful we can confirm both hypotheses. The
results of Chaw test yield F-value of 3.538 with P-value of 0.000 while Chi-Square value for Haman
test is 43.480 with P-value of 0.000. These are preliminary results for validating the model when the
level of significance is 5%. In addition, we have performed Breusch-Pagan test where F-value is
calculated as 23.959 with P-value of 0.000 and Durbin-Watson has been calculated as 1.79. These
statistical observations confirm the results.
,,,
2
253.40+0.0493 0.0074
t-student (7.315) (6.546) (1.103) 0.6608 13.427 0.000
it it it it
RI MV MVA
R F P value
ε
=++
==−=
(10)
As we can observe from the results of t-student value given in Eq. (9), t-student associated with MV is
statistically meaningful, which confirms the fourth hypothesis while t-student associated with MVA
is not statistically meaningful and we cannot confirm the fifth hypothesis. R-square yields 0.6608,
which means the independent variables can describe approximately 66% of the changes in dependent
variable. In summary, we can conclude that an increase of one percent in MV will increase 0.0493
unit in residual income.
4. Conclusion
In this paper, we have presented an empirical study to investigate the relationship between residual
income and other revenue based items such as dividend, operating cash flow, etc. The proposed study
of this paper gathered the financial information of all listed firms traded in Tehran Stock Exchange
over the period of 2007-2011. We only focused on listed companies whose fiscal years started from
March to May of each year. The other criterion associated with the proposed study of this paper is
that shares of the selected firms must have been active during period of study and there must be no
change in their fiscal calendar. The study did not include the shares of holdings, banks, insurance
firms. Finally, the information of the firms must be available for course of study.
The study used two linear regressions analysis and examined five hypotheses including the
relationship between residual income and other factors including dividend per share, value added
operating cash flow, value added cash flow, market cap and market value added. Using two
regression models, all these hypotheses have been investigated and the results of the survey
confirmed a meaningful relationship between residual income and dividend per share, value added
operating cash flow, value added cash flow. However, the results of the second model do not confirm
the last two hypotheses.
Acknowledgment
The authors are grateful for comments on earlier version of this paper specially the one, which was as
long as the first draft of the paper.
2856
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