In CFAI EOC5 (p.517) of the Residual Income Valuation chapter: Operating Profit = €10m Total Assets = €100m Half of the assets are financed with debt with a pretax cost of 9% Cost of equity capital is 12% Tax Rate = 40% What is the Residual Income? I calculate: Equity Charge = 50m x 0.12 = €6m RI = 10 - 6 = €4m But apparently that’s wrong. The solution uses WACC and I don’t understand why. Can someone shed some light?
Because you are given NOPAT, not Net Income
NOPAT = net operating profit after tax = EBIT (1−Tax rate)
Since this is a before interest figure, you need to include the total capital charge (debt and equity) when determining RI
Thanks ro424! But why would anyone use NOPAT? Wouldn’t an analyst always use Net Income since it’s readily accessible in the 10-K?
NOPAT does provide for some adjustments to R&D, Goodwill, Deferred Taxes, Operating Leases and LIFO Reserve that’s not accounted for in NI. So it’s just a different metric to use, normally under the EVA calculation of RI.
Breaking this down (mostly for myself as practice)
The question wants you to analyze the RI, provided with several metrics that dont’ really allow a quick traditional conversion to RI.
NOPAT = Profit before accounting for any costs of financing
Assets = Have to assume this is the “BV” (gross amount = Debt + equity)
ROE = We use ROIC in this case since we only know total assets, which equals debt + equity
Therefore you ROE becomes = NOPAT/Assets = ROIC
WACC = Cost of financing
Therefore, ((ROIC - WACC) * Assets) = RI
Vs.
(ROE - r) * BV = RI