Page 24 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 32.a: Calculate and interpret residual income, READING 32: RESIDUAL INCOME VALUATION
economic value added, and market value added.
MODULE 32.1: RESIDUAL INCOME DEFINED

Residual income (RI), or economic profit, is the net income of a firm less a charge that measures stockholders’ opportunity cost
of capital. The rationale for the residual income approach is that it recognizes the cost of equity capital in the measurement of
income. This concept of economic income is not reflected in traditional accounting income, whereby a firm can report positive net
income but not meet the return requirements of its equity investors.

EXAMPLE: Calculating residual income: Madeira Fruit Suppliers, Inc. (MFS) distributes fruit to grocery stores in large U.S.
cities. The book value of its assets is $1.4 billion, which is financed with $800 million in equity and $600 million in debt. Its
before-tax cost of debt is 3.33%, and its marginal tax rate is 34%. MFS has a cost of equity of 12.3%. MFS’s abbreviated income
statement is shown in the following figure.

Determine whether MFS is profitable by calculating residual income and
explaining its relationship to reported accounting income.

Even though MFS is profitable in
the traditional accounting sense, it
is economically unprofitable after
taking into account the necessary
charge to meet stockholders’
opportunity cost of supplying
capital to the company.