EVA/Economic Profit Vs. Residual Income

CFA Level II
#1

Since Economic profit (EVA) is calculated as the NOPAT - $WACC, isnt it equivalent to the Residual income, which is

Net income - equity charge => NOPAT - After tax Interst - Equity charge => NOPAT -$WACC

How are they different?

Can anyone help me out…

#2

So two thoughts here (don’t know if they’re right):

  1. Net income is not the same as net operating profit after tax. Net income is post interest and NOPAT is not. Right?

  2. WACC and the equity charge are not the same thing unless the firm is financed 100% with equity.

Anyone have input on this? Thanks!

#3

  1. You’re right. They are NOT the same. NOPAT is EBIT-Taxes, if I remember correctly.

  2. Also correct. Your equity charge will be the cost of equity * your beginning book value of equity.

#4

2 ways to calculate residual income. 1 through NOPAT - $WACC which is equivalent to EVA while the other one is through NI. Projecting the NI and adjusting from it the equity charge. If interest expense is treated similarly i.e. dollar amount & percentage, then both equations should yield the same RI.

#5

Interest Expenses treated similarly means that the interest expense which is deducted from EBIT is the only interest cost and it also reflects in WACC then RI should be same under both methods. If there is some interest income then both equations might not result in the same RI.

#6

I think NOPAT is EBIT(1 - tax rate)