Q35 R29 - economic profit interest, invested, total, economic

dirk01

CFAI answer seems wrong to me. Not sure where or how to report this mistake.

Economic Profit Question.

Company has $200,000 in Assets, $122,027 liabilities, $77,973 Shareholders Equity. EBIT is $30,000. Tax Rate of 40%. WACC given as 12%.

Problem specifically says, "Debt/Capital ratio is 50%." Therefore, interest bearing debt is assumed to be $77,973 and total invested capital is $77,973 * 2 or $155,946.

EP = NOPAT - $WACC

NOPAT is $30,000 * (1 - 0.40) = $18,000. I get the same result as CFAI, no quarrel here.


$WACC. CFAI says to take 12% (WACC) * $200,000 (Total Asset Value) = 24,000

Therefore EP = $18,000 - $24,000 or -6,000. Answer B.

In the real world of finance (ie. the non-textbook retarded CFAI viewpoint) and based on my experience the right way to calculate $WACC is:

12% * $155,946 = $18,713.52

You only take the WACC % off the capital that is assumed to be interest bearing or have a required rate of return. Other liabilities are assumed to be things like accounts payable which do not carry a cost of capital. It's the whole reason business models like Dell or Amazon.com (which pay their suppliers after receiving payment and have negative days working capital) are attractive because they are effectively getting 0% interest free loans to finance their business and that improves their economic profit.

So the REAL EP in this problem should be = $18,000 - $18,713.52 or -$713.52


Thoughts?



Edited 1 time(s). Last edit at Saturday, May 7, 2011 at 01:40PM by prophets.

scarecrow

I've passed through this kind of question on several mocks (CFAI and Schweser) and that's how its calculated. They multiply WACC by total assets. On 1 example, total assets = total fixed assets which is the only asset number given. They ask to calculate EP for year two where they'd deduct depreciation from fixed asset and multiply it by WACC.

Now if you think that their solution is retarded, then wait till you get to to the mock exams =)

President1988

It's just not the real world of finance. I'll give you another example:

If you were a retail store and you carried a brand of clothing like say Ralph Lauren clothes. And your trade policy w/ Ralph Lauren was that they deliver the inventory on your shelves and you only pay them 30 days after an item sells. Ralph Lauren doesn't require payment until delivery/purchase by your end customer. Is that inventory/asset being financed at the WACC? Absolutely not.

That Ralph Lauren inventory/asset is sitting on your shelves based on an interest free loan from your supplier. And a lot of inventory in the world is financed like this and it's not appropriate to just throw an economic rent/depreciation on it and include it in the economic profit calculation. It's an asset held at a 0% cost of capital, not at the WACC.

I know CFA tries to simplify some concepts, but these calculations just seem wrong to me.

bingbingliang

Couple thoughts:

1. Because the amounts given in the problem were: Equity was $77,793, Liabilities $122,027, Assets $200,000. If Debt to Capital is 50%, then debt is the same as the equity figure (they are both 50% each). So the interest bearing part or debt financed part of the liabilities is $77,793 of the $122,027 total liabilities figure. Therefore the invested capital base = $77,793 * 2 or (equity of $77,793 + debt $77,793).

2. I notice the problem specifically says, "Debt/Value is 50%." Not Debt/Capital (as I typed). Which is an oversight by my part and could possibly change the calculations slightly (but still leaving CFAI's answer as wrong). I'm not sure what Debt/Value actually implies and it's a pretty amorphous statement. Debt to value of what? Book value of assets? Value of capital invested in the business? I took it as being 50% of the capital invested in the business, so I just multiplied the equity figure by 2 and assumed the remaining liabilities to be non-interest bearing. But it's not entirely clear.

Outside of the poor wording, I still think they are teaching people the wrong way to calculate economic profit. It's not the way Goldman or Deustche Bank does it. I'm not familiar with anyone at any university teaching finance this way. The curriculum really should be changed.

Sportsman

Ya i got ya there just misread your info

Debt/Value... Thats pretty vague alright, but you would have to assume its debt/equity value. Debt/value is more commonly used in mortgagae markets, as in your loan/value ratio.