Page 16 - FINAL CFA II SLIDES JUNE 2019 DAY 6
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LOS 20.i: Distinguish among the economic profit, residual income, READING 20: CAPITAL BUDGETING
and claims valuation models for capital budgeting and evaluate a
capital project using each.
MODULE 20.3: REAL OPTIONS AND PITFALLS IN CAPITAL BUDGETING
Economic profit : measure in excess of the dollar cost of capital
invested in a project: EXAMPLE: Calculating economic profit: Using the data from our previous
example, calculate the economic profit for Blue Wave in years 1 through 4.
EP = NOPAT − $WACC
where:
NOPAT = net operating profit after tax = EBIT (1 − tax rate) Straight line depr
$WACC = dollar cost of capital = WACC × capital EBIT (1-t)
Capital = dollar amount of investment
12% * capital
The NPV based on economic profit is
called the market value added (MVA):
Notice that MVA = NPV?
Company value = Project NPV + initial investment = $168,467 + $400,000 = $568,467
Residual income focuses on returns on equity, determined by subtracting an equity charge from the accounting net income.
Calculate the NPV of the Blue Wave project and the company using the = $168,467, same prior methods!
residual income method.
Company value =
PV of the residual income +
equity investment (net worth in year 0) + = $168,467 + $115,767 + $284,233 = $568,467
Value of debt: at year 0
