Page 14 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 20.h: Calculate and interpret accounting income and READING 20: CAPITAL BUDGETING
economic income in the context of capital budgeting.

Economic income = after-tax cash flow plus the change in the MODULE 20.3: REAL OPTIONS AND PITFALLS IN CAPITAL BUDGETING
investment’s market value:

= cash flow + (ending market value − beginning market value) Accounting income = reported net income AFS resulting from an
Or investment in a project.
= cash flow − economic depreciation

where: Difference:
economic depreciation = (beginning market value − ending market value) Mainly because accounting depreciation based on the original cost, whereas
economic substance is based on MV;
EXAMPLE: Economic and accounting income: Blue Wave is a startup company that uses a brushless machine to wash cars. Suppose Blue Wave
makes an initial investment in equipment of $400,000. The equipment is depreciated on a straight-line basis over four years to a zero book value. At the end
of four years, the equipment will have a salvage value of $10,000. Blue Wave’s marginal tax rate is 30%. The company is financed with 50% debt and 50%
equity. The debt carries an interest rate of 6%, and the cost of equity is 19.8%. Blue Wave only expects to operate for the four year duration of the project,
so all income is distributed to bondholders and stockholders. The company plans to maintain a 50% debt to value ratio. Blue Wave expects to have sales,
expenses, and cash flows for the next four years as shown in the following figure.

The project’s required rate of return (i.e., its cost of capital) is the WACC. Calculate the
project’s NPV, economic income, accounting income, and discuss the differences
between the various income measures.

Answer: Calculate WACC:
= (0.198)(0.5)+(0.06)(1−0.3)(0.5)=0.12, or
= (0.198)(0.5)+(0.06)(1−0.3)(0.5)=0.12, or 12%