[ Music ] >> So next we're going to talk about a fix for the underinvestment problem that's induced by the use of return on investment. And that fix is a different financial performance measure, mainly residual income. Residual income is an income based return that takes into account the cost of capital, in essence, its profit or some income measure minus a cost of capital charge. So, residual income is the income measure that we use for the return on investment number, but taking into account explicitly the cost of capital. Cost of capital is calculated as the investment base times the cost of capital rate. In our example we referred to the cost of capital rate as 12 percent. So, turning back to table situation, we had return on investment before the gluten free option was implemented. And as we suggested, the return on investment for Division A was 20 percent and the return on investment for the B Division, again before the gluten free option is implemented, is 14.7 percent. Now, we can calculate residual income as something that compliments, or even substitutes for, return on investment measure. Before the gluten free option is being implemented, net income for Division A was $18,000. The investment in the company at that point in time, before the gluten free option was implemented, was $90,000. $90,000 times the 12 percent is $10,800. This incorporates a charge for the cost of capital that isn't currently included in the net income number. The difference between 18,000 and 10,800 is 7,200. So, before the gluten free option is implemented, the A Division is earning a residual income of $7,200. Analogous calculations are performed for the B Division. In a normal year, their income is 25,000, their investment before the gluten free option was $170,000. $170,000 multiplied by the 12 percent cost of capital rate is equal to 20,400. Leaving the residual income, income after the cost of capital is incorporated, to be $4,600. Now we can look at A Division and B Division, but after the gluten free option is implemented. Net income of A Division is the original $18,000 plus the $3,900 that's projected to be generated in income by the gluten free option for a total of 21,900. The investment base after gluten free would be 90,000 plus the $23,000 that it is required to purchase the ovens and other equipment to implement this option. That 90,000 plus 23,000 multiplied by the 12 percent cost of capital rate, yields a cost of capital of 13,560 and residual income resulting in 83 40. For Division B we have similar calculations, we have the original net income plus the gluten free net income, yielding a total of 28,900. And the total investment of B Division the original 170 plus the 23,000 it takes to get the gluten free option, multiplied by the 12 percent rate, yields 23,160. The difference between the income measure and the cost of capital charge is $5,740. So as you can see, if we were to use residual income as a financial performance measure, and managers were incentivize to increase residual income, both of these division's managers would likely invest in the gluten free option. The reason being, A Division's residual income moves from 7,200 to 8,340, that's an increase that's what the manger would be compensated higher for that increase l-- subsequently, and the same goes for the B Division, 4,600 transforms into 5,740. Again, if incentives were to be applied to residual income for these division managers, both would be incented to make the investment, which makes sense from the company's perspective, because as we mentioned the return on the investment from the gluten free option, surpass the threshold identified by upper management as necessary or worthwhile. So as you can see, the residual income measure, a key advantage of that, is that it mitigates the underinvestment problem. It will make both managers invest in the gluten free option in this example, when they should, when this option exceeded the threshold required by upper management. Historically however, the residual income measure is rarely used. Only General Electric really used it when it first was created. But today organizations are using different versions of this measure, some, some measure, some firms call it economic value added, other firms call it sharehold-- shareholder value add. The same principles apply there with a bit more complicated calculations. However the idea is the same. Calculate your profit, but incorporate the cost of capital as well, and that tells you the ultimate bottom line from a more economic perspective.