CFA Level II Exam · Residual Income Valuation

Residual Income and Equity Charge for CFA Level II

Updated 7 October 2026 · Fact-checked

Residual income is net income minus an equity charge, where the equity charge is beginning book value of equity times the cost of equity. It shows profit left after paying shareholders their required return. To solve questions, find the book value and cost of equity, compute the charge, then subtract it from net income.

Understand Residual Income Concepts and Equity Charge

Accounting net income looks at the cost of debt (interest) but ignores the cost of equity. A company can report a profit and still destroy value if that profit is less than what shareholders require. Residual income fixes this by charging for equity capital.

The equity charge is the dollar amount of return shareholders require in a period. It equals the cost of equity multiplied by the beginning-of-period book value of equity. Residual income (RI), also called economic profit or abnormal earnings, is net income minus this charge. If RI is positive, the firm earned more than investors required. If it is negative, it earned less.

You can also write RI in terms of ROE. RI = (ROE − cost of equity) × beginning book value of equity. This shows that RI is positive only when ROE is above the cost of equity. A firm with a small positive net income can still have negative RI.

Two related terms appear in vignettes. Economic value added (EVA) is a commercial version of residual income. It starts from net operating profit after tax (NOPAT) and subtracts a charge for all capital, debt and equity, at the WACC: EVA = NOPAT − (WACC × capital). Market value added (MVA) is the market value of the firm minus the capital invested. It is a stock measure. It equals the present value of all expected future EVA.

The key contrast: residual income deducts only the equity charge from net income, so it is an equity-level measure. EVA deducts a charge for total capital from operating profit, so it is a firm-level measure. Do not mix their inputs.

Key formulas to remember

Equity charge: Equity charge = cost of equity (r) × beginning book value of equity (B₀); Use beginning-of-period book value unless the question says otherwise.
Residual income: RI = net income − equity charge = NI − r × B₀; Also called economic profit or abnormal earnings.
RI using ROE: RI = (ROE − r) × B₀, with ROE = NI ÷ B₀; RI is positive only if ROE exceeds the cost of equity.
Economic value added: EVA = NOPAT − (WACC × total capital); Capital is debt plus equity. NOPAT = EBIT × (1 − tax rate).
Market value added: MVA = market value of the firm − capital invested; Equals the present value of expected future EVA.

How to solve Residual Income Concepts and Equity Charge questions

Use this method for any question on residual income, equity charge, EVA or MVA.

1Identify the measure asked: residual income (equity level) or EVA (total capital level).
2Pull the inputs from the vignette: net income or NOPAT, cost of equity or WACC, and book value of equity or total capital.
3Check which book value is given. Use the beginning-of-period figure for the charge.
4Compute the charge: r × B₀ for equity, or WACC × capital for EVA.
5Subtract the charge from net income (RI) or NOPAT (EVA).
6Interpret the sign: positive means value created above the required return, negative means value destroyed.
7For MVA, subtract invested capital from market value, and check the answer against the present value of future EVA if given.

Quickest way: ROE spread shortcut

When to use it: When the vignette gives ROE and book value but not net income, or asks whether value is created.

Compare ROE with the cost of equity first. If ROE is below r, RI is negative.
Compute the spread (ROE − r).
Multiply the spread by beginning book value to get RI.
Eliminate options with the wrong sign before doing any further arithmetic.

Common mistakes in Residual Income Concepts and Equity Charge

Using ending book value for the equity charge.
The balance sheet in the exhibit shows both years and the later one is easy to grab.
Fix: Use beginning-of-period book value unless the question states otherwise.
Using WACC to compute residual income.
EVA and RI sound alike, so the discount rates get mixed up.
Fix: RI uses the cost of equity against net income. EVA uses WACC against NOPAT.
Treating positive net income as value creation.
Accounting profit feels like success.
Fix: Always subtract the equity charge. Positive net income with negative RI means value is destroyed.
Confusing MVA with EVA.
Both are called value added.
Fix: EVA is a flow for one period. MVA is a stock: market value minus invested capital.
Using NOPAT in a residual income calculation.
Both are after-tax profit figures.
Fix: NOPAT is before financing costs and pairs with total capital. Net income is after interest and pairs with equity.

Worked examples

Example 1

Vignette: Lumora Ltd reported net income of $48 million. Beginning book value of equity was $400 million and the cost of equity is 10%. Questions: (1) What is the equity charge? (2) What is residual income? (3) What is the ROE?

Show the solution

Equity charge = 10% × $400 million = $40 million.
RI = $48 million − $40 million = $8 million.
ROE = 48 ÷ 400 = 12%.

Answer: Equity charge $40 million; residual income $8 million; ROE 12%. ROE exceeds the 10% cost of equity, so RI is positive.

Example 2

Vignette: Norvik Corp has NOPAT of $90 million, total capital of $800 million and WACC of 9%. Its market value is $1,000 million. Questions: (1) What is EVA? (2) What is MVA?

Show the solution

Capital charge = 9% × $800 million = $72 million.
EVA = $90 million − $72 million = $18 million.
MVA = $1,000 million − $800 million = $200 million.

Answer: EVA is $18 million and MVA is $200 million. Positive EVA and positive MVA both indicate value creation.

Exam tips

Read which rate the vignette gives. Cost of equity points to residual income. WACC points to EVA.
Check the sign of RI by comparing ROE with r before calculating.
Watch the units and the year: beginning book value, not ending.
Remember that MVA is the present value of future EVA, a common conceptual question.

Residual Income Concepts and Equity Charge in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Residual Income Concepts and Equity Charge: frequently asked questions

What is the residual income formula?

Residual income equals net income minus the equity charge. The equity charge is the cost of equity times beginning book value of equity. Equivalently, RI = (ROE − r) × beginning book value.

What is the difference between residual income and EVA?

Residual income is net income less a charge for equity only. EVA is NOPAT less a charge for all capital at WACC. RI is an equity-level measure and EVA is a firm-level measure.

Why can a profitable firm have negative residual income?

Net income only deducts interest, not the cost of equity. If net income is below the equity charge, shareholders earn less than they require and RI is negative.

What is market value added?

MVA is the market value of the firm minus the capital invested in it. It equals the present value of all expected future EVA.