Page 24 - FINAL CFA II SLIDES JUNE 2019 DAY 8
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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 less a charge for stockholders’ opportunity cost of capital. The
rationale is to recognize that a firm can report positive net income but not meet the return requirements of its equity investors.
EXAMPLE: MFS distributes fruit to grocery stores in large U.S. cities. The BV 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 RI and explaining its relationship to Even though MFS is profitable in the traditional accounting sense, it is
reported accounting income. economically unprofitable after taking into account the necessary charge
to meet stockholders’ opportunity cost of supplying capital to the company.
