I know the formula for accounting income is (Sales-Costs-Depreciation-Interest Expense)(1-tax rate). Why don’t you add back the depreciation like you do with the economic income formula, (S-C-D)(1-tax rate)+D? It would just help me remember on a conceptual level, is all. Thanks guys!
WOW someone just asked this. What a coincidence! I didn’t realize this! Sorry about the duplicate question.
accounting income is nothing but your net income… so why would you want to add back depreciation to that?
operating costs=fixed and variable are included in both but the difference here is that economic income is the after-tax cash flow so for that reason you have add back non-cash charges, which is the depreciation in this case. so after tax cash flow to calculate EI = (S-D-C)(1-T) + D or EBIT(1-T) + D bare in mind interest expense is excluded because it is included in the WACC when u discount it. AI is NOT a cash flow number but u have to subtract Dep to arrive to net income, thats why u subtract it in the first place but DONT add it back at the end. so AI = (S-C-D-I)(1-T)
great explanation. so is this true: after tax cash flows = economic income = NI + Depreciation
No; economic income for year x=After-tax CF for year x +(Sum of all future cash flows at the end of the year minus sum of all future cash flows at the beginning of the year). The after tax cash flow does not equal the economic income. Technically, I hate introducing the term Net Income into this because that includes interest expense, which is not in economic income, but ACCOUNTING income is equal to Net Income. You could say add back the interest expense that’s usually removed when arriving at net income and say that economic income=Net Income+after-tax interest expense+depreciation but that would confuse the hell out of me.
Economic income for year x=After-tax CF for year x +(Sum of all future cash flows at the end of the year minus sum of all future cash flows at the beginning of the year). The after tax cash flow does not equal the economic income. You are right about the above. I remember this was on the next page (pg 37). To calculate the sum of all future cash flows you would probably have to computer the After tax cash flow for each year and then discount each one right?
Yes, you would calculate the ATCF for each year plus add the terminal value to the last year as part of that cash flow. Just remember don’t include the $200,000 initial outflow they give in the example when calculating the future cash flows, meaning Economic Income year 1= ATCF1+[(Year 2 ATCF+Year 3 ATCF+ Year 4 ATCF & terminal value) - (Year 1 ATCF + Year 2 ATCF + Year 3 ATCF + Year 4 ATCF & terminal value)].
Economic Income year 1= ATCF1+[(Year 2 ATCF+Year 3 ATCF+ Year 4 ATCF & terminal value) - (Year 1 ATCF + Year 2 ATCF + Year 3 ATCF + Year 4 ATCF & terminal value)]. yup. since the cash flows remaining at the end of the year are less than the remaining cash flows remainiing at the beg of the year, your economic income each year will be ATCF of that year minus some #. Therefore, this is why economic income (i believe on pg 36 or 37( is also referred to as ATCF- economic depreciation. with me?
Right. ATCF+(Ending-Beginning)=ATCF-(Beginning-Ending)=ATCF-Economic Depreciation
good job man. lets kill this thing. btw there is a good question just like this on sample 3. in addition to this way were discussing, they show an alternate way of finding EI by just doing MV at time t times the required return. not sure what this is about so ill stick with schwesers method.
hey rellision not sure if youre still following this thread but another more simple way to find the EI(t) = BegMV(t) x WACC Also, i’m having an issue again with calculating interest expense after doing sample 3. SPOILER ALERT: SAMPLE 3 On a sample problem, interest expense is calculated as (weight of debt financing) x (initial cash outlay) x (before tax cost of debt). However, check out Schweser page 39 of Book 3, which is what you brought up before. This is a similar problem. Look at how they calculate the interest expense there: (weight of debt financing) x (MV of the firm at the beginning of the year) x (before tax cost of debt). The initial outlay in the Scwheser problem is untouched fofr pursposes of interest expense.
DUDE WHY DO THEY NOT TELL US THIS IN THE BOOK? Does this formula always work? Cpk? Swaption? Any objections or modifications or times that Economic Income=(Beginning Year Market Value)*(WACC) doesn’t work?
Economic Income definitely is not this formula that rellison has above. Economic Income = ATCF - (Economic depreciation) = ATCF - (Beginning BV - Ending BV) Beginning BV * % of Debt * Rate of Debt = Interest Expense. Book value = NPV of project + Initial Outlay. Both the Sample 3 (as stated by The show) and the book are calculating the interest expense the same way. do not see where the confusion is.
I think in Sample Exam #3, the “500000” amount is the interest expense; the (.4)(38 million)(.12) is the total costs. They are using the equation (S-C-D-Int Exp)(1-tax rate). I think.
But cpk how come it works? If you look at the economic income example on page 36, book 3 in Schweser’s example shows that if you take the beginning market value times the WACC (in the example, it’s 12%), it does come out to the economic income for that year. Is it a coincidence?
The formula actually does work CPK. Try it on the formula on page 37 of Schweser. Year 1: Beg MV x WACC = 522,906 x .12 = 62,748.72 (same as Schweser’s way) Just to test for consistency: Year 4: Beg MV x WACC = 150,893 x .12 = $18,107.16 (same as Schweser’s way) It’s actually not a HUGE shortcute because you still have to find the Beg MV. You just don’t have to find ending MV. ---------------------------------------------- As far as the interest expense: CPK, im not sure if you can access sample 3 or have done it, but in the question (i think it’'s 14), they multiply by the initial outlay of 38M. in schweser page 39, they multiply by the beginnning MV. the initial outlay of 200,000 is not used.
rellison Wrote: ------------------------------------------------------- > I think in Sample Exam #3, the “500000” amount is > the interest expense; the (.4)(38 million)(.12) is > the total costs. They are using the equation > (S-C-D-Int Exp)(1-tax rate). > I think. no the 500,00 is the fixed costs. they show the income statement and they put a star next to int exp and they show the calc as 0.4 x 38 x .12
that is I think a rule, that should happen. Project WACC=12% = Economic Rate of Return. Project discounted cashflows are at 12%. and your next period sum of cash flows is also at 12%. so economic depreciation is essentially reflecting 12% factor too. The same (but with 10%) is happening on the text book in the Granite Corporation example.
cpk I think he’s right: The problem gives **SPOILER** Initial Capital Outlay: $38 million LIfe of Project: 3 years Increase in working capital investment: $1 million Depreciation Schedule: 50% (Year 1); 30% (Year 2); 20% (year 3) Salvage value at end of project: Zero Labor Savings, Year 1: $24 million Annual Growth rate of Labor Savings: 20% Tax Rate: 40% Before-Tax Cost of Debt: 12% Company’s Cost of Capital: 15% Accounting Income=$24 million- (.4)($38 million)(.12) - (.5)($38 Million) - $500000 which is consistent with (Sales-interest expense-depreciation-costs)*(1-tax rate).