NOTE: SMALL SPOILER OF ONE QUESTION OF SAMPLE 3 I recall Schweser saying that the two differed because 1) accounting income used historical costs and not market costs and 2) accounting income included the effects of interest cost whereas with economic income, the interest cost is already included in the WACC. In Sample 3, a question asks to calculate accounting income. The formula = (Sales - Dep - intexp - fixed costs)(1-T) = NI = accounting income. I realize that if it were economic income, Dep would be added back at the end. But in the accounting income formula why is Dep subtracted at all if accounting income doesnt take Dep into consideration? Can you just think of accounting income as regular net income? Also, are fixed costs included in the calculation of economic income?
operating costs=fixed and variable are included in both but the difference here is that economic income is the after-tax cash flow so for that reason you have add back non-cash charges, which is the depreciation in this case. so after tax cash flow to calculate EI = (S-D-C)(1-T) + D or EBIT(1-T) + D bare in mind interest expense is excluded because it is included in the WACC when u discount it. AI is NOT a cash flow number but u have to subtract Dep to arrive to net income, thats why u subtract it in the first place but DONT add it back at the end. so AI = (S-C-D-I)(1-T)
Economic income and accounting income both include all costs, fixed and variable. It’s just the same formula you were learning for after-tax cash flow for replacement projects: (Sales-Costs-Depreciation)(1-tax rate)+Depreciation or EBIT(1-tax rate)+Depreciation or (Sales-Costs)(1-tax rate)+(Tax Rate*Depreciation). The difference seems to be for some weird reason, that you don’t add back depreciation for accounting income. When in doubt, memorize it. Also, remember that you don’t include the initial capital input (i.e., the initial invesment) when calculating interest expense; int expense=(PV of all future cash inflows)*(pre-tax cost of debt also known as interest rate if they give it to you that way)
rellison looks like we think alike. although your first paragraph is crystal clear now i dont have aclue what youre talking about in paragraph 2. ive never seen the interest rate derived by taking the cost of debt times the PV of inflows. there was a q on the sample where the interest expense is interest rate times capital investment times percent of debt. this is intuitive to me, hopefully this is how were given it.
That is from Schweser. Do you have Schweser? In book 3, page 36, there is an example and then they calculate economic income and accounting income. In that problem the firm finances the project with 50% equity and 50% debt. They mention at the top of page 39, “Interest expense in calculated by assuming that Blue Wave finances 50% of the project’s market value with debt at a pre-tax cost of debt of 6%. Each year, interest expense is equal to 6% of a beginning market value times 0.5.” All I’m saying is that interest expense is the proportion of the project financed with debt multiplied by the given rate of interest which in some problems might not be given outright, but it’s the pre-tax cost of debt that you use to calculate the WACC. You use the pretax cost and not the after-tax cost because the tax is taken out at the end in the equation (Sales-Cost-Dep-Int Exp)*(1-tax rate).
im not disagreeing with u. i saw pg 36 in book 3 last night actually. it is the method i described that i did above on the sample, where you take int rate x MV x weight of debt to get the int exp. this sounds very different from your earlier statement about PV of cash flows.
also, just want to confirm: NI + Dep = after tax cash flows = economic income The NI in the line above = accounting income All true?
See my above post. I could be wrong. If I am, please tell me!