James Case and Erica Gallardo are considering differences between accounting income and economic income when evaluating capital projects. Case makes the following statements to Gallardo: Statement 1: One of the main reasons why accounting income and economic income will differ is that interest expense is subtracted when calculating accounting income, but is not considered when computing economic income. Statement 2: Another reason why accounting income and economic income may differ is that accounting depreciation is based on original costs while economic depreciation is based on market values. Gallardo considers both of Case’s statements. Are Case’s statements 1 and 2, respectively, CORRECT? Statement 1 Statement 2 A) Yes Yes B) Yes No C) No Yes D) No No
A
I will go with “A” again.
I am going with C again. Isn’t economic income something like what income is actually available to you after taking into consideration all factors. So interest should be deducted as well. I think…
wanderingcfa Wrote: ------------------------------------------------------- > I am going with C again. > > Isn’t economic income something like what income > is actually available to you after taking into > consideration all factors. So interest should be > deducted as well. I think… I’m going to agree and say C as well. Wouldn’t adding back in interest A apply only if you were trying to figure out income available to all sources of capital (Debt & Equity)?
Geez… I say “D”
Your answer: C was incorrect. The correct answer was A) Yes Yes Case has accurately described the two major differences between accounting income and economic income. Accounting depreciation is based on the original cost of an investment, while economic depreciation is based on the market value of the asset. Also, the interest expense that is subtracted from accounting income is not considered when computing economic income because interest expenses are implicit in the required rate of return used to calculate the asset’s market value. I would have thought that interest expense is considered as part of the WACC calculation.
I’m gonna say C) I know the first question has something to do with opportunity cost being accounted for, as this was from level 1…I just can’t recall if is explained through interest expense? The second part sounds correct as you’d be trying to reflect the “true” picture of the firm at that point in time.
Thepinkman, keep firing these good conceptual questions!
Schweser explains this as follows: Accounting Income: -Financing costs (e.g., interest expense) are considered as a separate line item and subtracted out to arrive at net income. -Interest expense is deducted from the accounting income figure. Economic Income: -In the basic capital budgeting model, financing costs are reflected in the WACC. -Interest expense is ignored when computing economic income because it is reflected in the WACC. Wouldn’t you still say that interest expense is “considered” when calculating economic income?
Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements: Statement 1: The value of the tax shield provided by debt can be calculated by multiplying the pre-tax cost of debt by (1 – tax rate). Statement 2: If a company is profitable, the value of its tax shield will be positive and its value will increase as its leverage increases, all else equal. Are Palmer’s statements accurate? Statement 1 Statement 2 A) No Yes B) No No C) Yes No D) Yes Yes Your answer: A was correct! Palmer’s first statement is incorrect. The calculation Palmer describes is the calculation for the after-tax cost of debt. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure. Palmer’s second statement is correct. The tax shield adds value to the firm so that the value of a levered firm is greater than the value of an unlevered firm, all else equal.
A is correct for the second question. I would’ve picked C for the first one - though the question reminds me now of not including financing charges in project cash flows in Corporate Finance. Good questions!
Here’s a follow-up to the first question in this thread: All of the following statements highlight the differences between accounting profit and economic profit EXCEPT: A) the costs used in computing economic profit include the cost of capital. B) economic profits are cash-based whereas accounting profits are based on accrual accounting methods. C) economic profits are less susceptible to management manipulation than accounting profits. D) economic profit is expressed as a return while accounting profit is expressed in dollars.
D. Economic Profit can be a dollar amount. And the whole thing regarding economic profits is its’ ‘Cash-based’ which is not as manipulable.
Isn’t Economic profit = Accounting profit - Equity charge ? Could someone direct me to the reading that addresses economic profit ? Thanks !
Its in corp finance and equity. NOPAT - $WACC
For plyon’s question. D - agree with thepinkman
For those answering my question with “D”… What is ROE?
ROE = NI/Equity Where Economic profit = EBI - (Capital * WACC). Confused?
Ok, I change my answer to A. I see how economic profit is actually your return on capital invested. Which is the same concept of ROE. I am not sure why economic profit would not be expressed in dollars though?