I am talking about reading 37 question 5, the question says to decide a company’s residual income above or below 0, it can compare net operating profit after taxes as a percentage of its total assets can be compared with its weighted average cost of capital (WACC).
I did the old fashioned Operating profit after tax -interest(1-t)-equity charge, but can someone help me understand the rational of the original question?
Residual Income and economic profit are linked. One is from the only-equity perspective and the latter is from the whole-firm perspective.
You can also calculate RI from those numbers. I will show.
EBIT*(1-t) = 10
EBIT = 10 / (1 - 0.40) = 16.67
Assets = 100 >>>> 50% financed with debt
Debt = 50 anb Equity = 50
Pretax cost of debt = 9%, so interest expense is 50 * 9% = 4.5
I’m looking for Net Income:
EBT = 16.67 - 4.5 = 12.17
Taxes = 12.17 * 40% = 4.87
Net Income = 12.17 - 4.87 = 7.3
Cost of equity = 12%
Residual Income = 7.3 - 50 * 12% = 1.3 (positive RI)
Hope this helps!
Good question. It shows you that the % of return on net operating profit after tax above the WACC is the % RI.