According to V4, p. 598 of the CFAI text, a drawback of the residual income model is that “The RIM’s use of accounting income assumes that the cost of debt is reflected appropriately by interest expense.” I’m a little lost on that one - can someone flesh it out for me? Thanks.
you assume debtholder’s (or any interest-bearing securities senior to common stock) are paid what they are owed, timely interest etc. this interest should be reflected in the interest expense…to make it more complicated, we hope lease expense when capitalized is appropriated to interest if NOT then the cost of debt is not accurate and the residual income is not correct…(i include leases as debt bc they are senior to common stock in bankruptcy)
Residual Income could also be calculated using NOPAT - WACC$ I guess using accounting income assumes that the debt portion of the WACC$ is the same as interest…If interest expense is the true cost of debt then these two methods will give the same answer.
Thanks!
I thought NOPAT - $WACC is economic profit…?
EVA = NOPAT - $WACC
NOPAT- $wacc = economic profit NI-R invested capital = RI