Hi.
In the Schweser Q&As, in one of the Correct / Incorrect questions, the following is shown to be a correct statement:
“The present value of future economic profit will be the same as the NPV found by discounted cash flow analysis in the basic capital budgeting approach if the WACC is used as the economic profit discount rate”.
I am confused by this, because for DCF analysis, we use cash flows (which includes non cash items like depreciation). However, for Economic Profit, we use the formula NOPAT - $WACC.
How, then, can both these methods arrive at the same NPV?
Thank you
You need to look at the discount rate.
Economic Profit is NOPAT - $WACC. However, this is only the economic profit that you would calculate in each year (similar to residual income). In order to get to NPV, you need to then discount these economic profits using the WACC and sum them up. This is also called market value added, MVA, so it is a firm perspective rather than a pure equity perspective.
With DCF-analysis, Schweser refers to FCFF, because that’s where we use the WACC as the discount rate in order to arrive at firm value.
Consequently, NPV (or firm value) should be identical in both cases.
Hope this helps.