Is Residual Income the same thing as Economic Profit? I’ve always thought Econ Profit as EVA but in Schweser book 3 page 274 the first sentence it says: "Residual Income (RI), or economic profit, is the net income of a firm less a chrrge that measurs stockholders’ opportuity cost of capital. " and… no other reference about economic profit. (I dont have the CFAI book with me atm but will check on it when I do have it).
They are different. Economic Profit=NOPAT-WACC The WACC=(WACC)(Capital) The RI is RI=NI-Equity Charge The equity charge=(rce)(capital)
It depends on how the WACC is calculated, if the cost of debt used to calculate WACC is the same as the rate that will provide the interest expense on the income statement EVA and RI should be equal. But since that isn’t always the case, don’t assume they will be the same for the test.
bhans2 Wrote: ------------------------------------------------------- > It depends on how the WACC is calculated, if the > cost of debt used to calculate WACC is the same as > the rate that will provide the interest expense on > the income statement EVA and RI should be equal. > But since that isn’t always the case, don’t assume > they will be the same for the test. Dude, what are you talking about? WACC and required return on equity are calculated differently.
RI = NI - (BV of equity * Re) EVA = EBIT(1-t) - $WACC (EBIT)(1-t) - Interest(1-t) = NI $WACC = (cost of debt * total debt)(1-t) + (Re * BV of equity) Therefore, if (Cost of debt * Total Debt)(1-t) = Interest Expense(1-t) then RI = (EBIT(1-t) - Interest Expense(1-t)) - (Re * BV of equity) and EVA = EBIT(1-t) - (Interest Expense(1-t) + (Re * BV of equity)) And (EBIT(1-t) - Interest Expense(1-t)) - (Re * BV of equity) = EBIT(1-t) - (Interest Expense(1-t) + (Re * BV of equity)) For example if EBIT(1-t)=5, Interest Expense(1-t)=2, and (Re * BV of equity)=1 (5 - 2) - 1 = 2 and 5 - (2 + 1) = 2 Therefore, if (Cost of debt * Total Debt)(1-t) = Interest Expense(1-t) then EVA = RI