Review of Accounting Studies, 7, 283–287, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discussion of: “Controlling Investment Decisions:
Depreciation and Capital Charges”
Carnegie Mellon University, Graduate School of Industrial Administration, Pittsburgh, PA 15213-3890
Residual income based performance evaluation has received a great deal of attention in
both the popular press and in academic research. To the best of my knowledge, Dutta and
Reichelstein (2002) is the ﬁrst principal-agent model to provide a rationalization for the use
of residual income in which the conﬂict of interest between the principal and agent over
project selection arises endogenously.
Suppose an owner has an investment opportunity that requires a cash outﬂow of 109 today
and will produce equal cash inﬂows at the end of the next two years. The annual cash
inﬂow is equally likely to be 72 or 108 per year. The owner’s discount rate is 20%. Either
type of project has a positive NPV and, hence, should be accepted: −109 + 72/(1.2) +
= 1 and −109 + 108/(1.2) +108/(1.2)
= 56. Now, suppose the decision rights
for project acceptance resign with an (investment center) manager. There is no other agency
problem. The owner’s objective is to compensate the manager in such a way that he has
strict incentives to accept all positive NPV projects and strict incentives to reject all negative
NPV projects. This can be accomplished by basing the manager’s pay on residual income.
For simplicity, suppose residual income for a period is simply the period cash inﬂow less
depreciation less a capital charge (based on the beginning of period book value of the asset
and the owner’s discount rate). Hence, if straight-line depreciation is used for the 72 inﬂow
project, the present value of residual income discounted using the owner’s discount rate is
(72 − 54.5 − (0.2)(109))/(1.2) + (72 − 54.5 − (0.2)(54.5))/(1.2)
= 1. That is, the NPV
of the project and the present value of its residual income are equivalent when evaluated at
the owner’s discount rate. Moreover, this (well known) equivalence does not depend on the
depreciation method used.
The catch is that the manager may have a discount rate higher than the owner’s. Suppose
the manager’s discount rate is 100%, yielding a present value of residual income for the
72 inﬂow project of (72 − 54.5 − (0.2)(109))/(2) + (72 − 54.5 − (0.2)(54.5))/(4) =−0.5.
The manager would not undertake the project. The solution proposed by Reichelstein (1997)
and Rogerson (1997) is to use relative beneﬁt depreciation, which makes the total charge
(depreciation plus the capital charge) proportional to the relative contribution of each