The Strategic Role of 'Cost of Capital' in Residual Income Measurement

This paper examines the strategic role of quot;cost of capitalquot; in residual income measurement in an oligopoly. Because of imperfect competition in the product market, firm market valuation and managerial performance evaluation based on residual income measures or Economic Value Added (EVA) are most closely related to each other so that an interactive effect arises. Facing a stochastic production-technology with diminishing marginal returns in the decision context of capital investment, firm owners can use the quot;cost of capitalquot; in residual income measures as a competitive tool for their managers. We show that the mode of competition (i.e., Cournot versus Bertrand) has a significant impact on the strategic role, and determines whether the firm owners levy a lower or higher quot;cost of capitalquot; on their managers than their own opportunity cost of capital. They will charge the managers with their own cost of capital if, and only if, their managers' actions do not cause their competitors to counteract so that the firm's market value is affected (i.e., price-takers in perfect competition or price-setters in monopoly). Consequently, imperfect competition separates the capital's ownership and management, and perfect competition or monopoly unites the two.We consider three different sources of uncertainty: industry-wide demand, firm-specific technological input and output. Our results prove that neither industry-wide demand uncertainty nor firm-specific input uncertainty affects the equilibrium quot;cost of capital.quot; Furthermore, firm-specific output uncertainty moves the equilibrium quot;cost of capitalquot; closer to the firm owners' own cost of capital, and hence, makes the strategic role less valuable, although its effect on the strategic role is of secondary relative to that of imperfect competition