LOS h: Calculate and interpret accounting income and economic income in the context of capital budgeting.

Q1. Jackson Huang is an analyst for Oswald Technologies. Huang is considering a $150 million capital project that is expected to produce operating earnings before interest and taxes of $80 million per year for all three years of the project’s life. The project is being depreciated on a straight-line basis and at the end of 3 years the project will have zero salvage value. Huang believes the project is an average risk project for the firm and is planning to apply Oswald’s weighted average cost of capital (WACC) of 8% and tax rate of 30% to the project. Huang’s supervisor has asked him to use both the economic income and economic profit approaches to analyze the project. After completing his analysis, Huang makes the following statements to his supervisor.

Statement 1:     In the first year of the project’s life, the economic income exceeds the economic profit generated from the project.

Statement 2:    The discount rate applied to the economic profit to calculate the project’s net present value (NPV) will be identical to the economic rate of return earned by the project each year.
How should Huang’s supervisor respond to his statements?

A)   Agree with one only.

B)   Agree with both.

C)   Agree with neither.

Q2. Firehouse Company is investing in a

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Q1. Jackson Huang is an analyst for Oswald Technologies. Huang is considering a $150 million capital project that is expected to produce operating earnings before interest and taxes of $80 million per year for all three years of the project’s life. The project is being depreciated on a straight-line basis and at the end of 3 years the project will have zero salvage value. Huang believes the project is an average risk project for the firm and is planning to apply Oswald’s weighted average cost of capital (WACC) of 8% and tax rate of 30% to the project. Huang’s supervisor has asked him to use both the economic income and economic profit approaches to analyze the project. After completing his analysis, Huang makes the following statements to his supervisor.

Statement 1:     In the first year of the project’s life, the economic income exceeds the economic profit generated from the project.

Statement 2:    The discount rate applied to the economic profit to calculate the project’s net present value (NPV) will be identical to the economic rate of return earned by the project each year.
How should Huang’s supervisor respond to his statements?

A)   Agree with one only.

B)   Agree with both.

C)   Agree with neither.

Correct answer is A)

To answer the first question, we need to calculate the economic income and economic profit for the first year of the project. Economic income is the after-tax cash flow plus the change in market value for an investment.
Cash flow = operating income (1 ? T) + depreciation = $80(1 ? 0.30) + $50 = $106 million.
Next determine the current market value of the project as: (106 / 1.08) + (106 / 1.08²) + (106 / 1.08³) = $273.17 million. The value after Year 1 = (106 / 1.08) + (106 / 1.08²) = $189.03 million. The change in market value = (273.17 ? 189.03) = $84.4 million. The economic income is $106 ? $84.4 = $21.86 million.
Economic profit = NOPAT ? $WACC = EBIT(1 ? T) ? $WACC
Economic profit (Year 1) = $80(1 ? 0.30) ? 0.08($150) = $44 million
Huang’s supervisor should disagree with the first statement as the economic profit of $44 million exceeds the economic income of $22 million.
Huang’s supervisor should agree with the second statement. The discount rate applied to the economic profit to determine the project’s NPV is the WACC. The economic rate of return using the economic income approach will be equal to the WACC, so the rates are identical. We can take the first year’s economic income divided by the market value of the project and see that the economic rate of return is the same as the WACC. ($22 / $273) = 0.08, or 8%.

Q2. Firehouse Company is investing in a