Module 20.3 LOS 20.i: Economic profit, residual income, and claims valuation models

Economic profit is a measure of profit in excess of the dollar cost of capital invested in a project:

EP = NOPAT − $WACC

where:

NOPAT = net operating profit after tax = EBIT (1 − tax rate)

$WACC = dollar cost of capital = WACC × capital

Capital = dollar amount of investment

Residual income focuses on returns on equity and is determined by subtracting an equity charge from the accounting net income. The equity charge is found by multiplying the required return on equity by the beginning book value of equity.

The calculation for residual income is:

residual income = net income − equity charge

or

 = NIt − reBt-1

where:

RIt = residual income in period t

NIt = net income in period t

re = required return on equity

Bt–1 = beginning of period book value of equity

Like other capital budgeting methods, discounting the residual income at the required rate of return on equity will give the NPV of the investment.

Claims valuation separates cash flows based on the claims that equity holders and debtholders have on the asset. Cash flows to debt holders are discounted at the cost of debt and cash flows to equity holders are discounted at the cost of equity. The present value of each set of cash flows is added together to determine the value of the company.

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