when calculating economic income (re: capital budgeting) in the terminal year of the project, is the after-tax inclusive of the disposition of the the asset? So… essentially is the cash flow for YR 2 on the problem below 85 or 70? Fontenot Company is investing $100 in a project that is being depreciated straight-line to zero over a two year life with no salvage value. The project will generate EBIT of $50 each year for two years. WACC and required rate of return of project both 12% and tax rate 30% What is the economic income for the Fontenot Company in YR 1 and YR 2? A. 9.11 and 17.24 B. 17.24 and 9.11 C. 17.76 and 24.89 D. 24.89 and 17.76
Im stuck on this problem as well can someone please explain? The answer shows that we have to discount 85 by the WACC in years 1 and 2. Where does the 85 CF figure come from? Thanks
Hi guys… Of course:
We will start at the income statement
EBT = 50
(-) Taxes = 15 (50*0.3)
(=) EAT= 35
(+) depreciation= 50
After tax cash flow = 85
THEN: economic income for Y1
Beginning market value= 143.65
Ending market value of the investment = 75.89
After tax cash flow = 85
Economic income for Y1= 85 - 143.65 + 75.89 = 17.24
THEN: economic income for Y2
Beginning market value= 75.89
Ending market value of the investment = 0
After tax cash flow = 85
Economic income for Y1= 85 - 75.89 + 0= 9.11
Explaining:
When you add depreciation to operating income after taxes (EAT) you get the After tax operating cash flow (the ones you will always discount to get NPV)
To get Economic income = after tax operating cash flow - (bgn market value - ending market value)
To get beginning market value = NPV of the cash flows (without taking into account the initial outlay) at a 12% rate, then NPV= cash flow 1 = 85 and cash flow 2 = 85 discounted at 12%
To get ending market value (will be the beginning market value of the next year)= we need to know the NPV of the remaining cash flows then:
NPV= cash flow 1 = 85 discounted at 12%… since we have to other remaining cash flows the ending market value for Y2 is zero.
Y1 Y2
Beginning market value: 143.65 75.89
End market value: 75. 89 0
Thank you so much for the explanation! This really helped me understand the economic depreciation portion as well. Follow up question, the next part asks that we calculated economic profit. I understand the formula for yr 1 is (50k)(1-.3) - 0.12(100) which gives 23 for year 1. However, on year 2 the only change is that they use 50 instead of 100 for the capital amount. Can you please help me understand why we would reduce the capital invested to 50? Thanks!