Incentive Properties of Residual Income When There is an Option to Wait

Performance measures based on residual income are increasingly popular. The academic lit-erature shows that residual income has important incentive properties when management bases investment decisions on the net present value (NPV) rule. My analysis focuses on the case in which investment decisions can be postponed, when management must extend the simple NPV rule by considering an option value. My analysis shows that some important in-centive properties of residual income still hold when there is an option to wait, but only when the residual income measure is correctly adjusted. I also provide an incentive-based explana-tion of why the capital charge rate within firms is often significantly higher than the firm's cost of capital.