101 Concepts for the Level II Exam

Level II Concept 35: Economic profit, residual income, and claims valuation

Economic profit takes the perspective of all investors (debt and equity)

Economic profit: EP = NOPAT – $WACC

where NOPAT = Net operating profit after tax = EBIT(1 – Tax rate) and $WACC = Dollar cost of capital = WACC * Capital.

When applied to the valuation of an asset or security, the NPV of an investment (and its market value added) is the present value of future EP discounted at the weighted average cost of capital.

NPV = MVA = Σ EPt/ (1 + WACC)t

The total value of the company (of the asset) is the original investment plus the NPV.

Residual income

Residual income = Net income – Equity charge, or RIt = NIt – reBt–1

where RIt = residual income during period t, NIt = net income during period t, re = cost of equity, and Bt–1 = beginning-of-period book value of equity.

The NPV of an investment is the present value of future residual income discounted at the required rate of return on equity:

NPV = Σ RIt / (1 + re)t

The total value of the company (of the asset) is the NPV plus the original equity investment plus the original debt investment.

Claims valuation

The basic capital budgeting approach is to value assets, which are on the left-hand side of the balance sheet. However, the claims valuation approach values the liabilities and equity (the claims against the assets), which are on the right-hand side of the balance sheet. The value of the claims should equal the value of the assets.

One simplistic approach is to find the present value of payments to bondholders and stockholders

  • Interest payments
  • Principal payments
  • Dividends
  • Stock repurchases

In theory, all three valuation methods are equivalent and will give the same results.