The main result of the paper is that the optimal capital charge rate for computing residual income always exceeds the required rate of return as a result of empire benefits.
The capital charge rate employed is also often referred to as a hurdle rate.
The practitioners' literature advocates using the firm's cost of capital as both the required rate of return and the capital charge rate (Brealey and Myers 2000; Young and O'Byrne 2001).
In particular, I compare the optimal required rate of return with the optimal capital charge rate and benchmark both these hurdle rates against the firm's cost of capital.
4) In contrast to the ambiguous results for the required rate of return, the optimal capital charge rate under delegation always exceeds the cost of capital.
The model analysis also shows how the capital charge rate
used for performance evaluation purposes should vary with the riskiness of the investment project.
The capital charge rate used in the residual income measure, however, must equal the owner's optimal hurdle rate, not her actual cost of capital.
Therefore, residual income corresponding to the capital charge rate of h is:
On the other hand, if the capital charge rate h equals the owner's cost of capital c, the manager will undertake the project whenever its net present value is positive, and reject the project when it is negative.
If the owner sets the capital charge rate equal to the hurdle rate [r.
At the same time, the manager will adopt the optimal project acceptance rule only if the capital charge rate equals r*.
To ensure such consistent valuation, capital charge rates
for Departments must be increased (to yield pre-company tax rates) so that project valuations are at least approximately consistent with company tax paying entities.