Economic Income and Economic Profit

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icetonez

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Did anyone else get tripped up by this the first time through? I didn’t even realize they were different things at first. I guess I need to read/listen more carefully.
Let’s see if I’ve got this now:
Economic profit is the after-tax operating cash flow or NOPAT, which is EBIT (1 - tax rate) less the dollar value weighted average cost of capital or $WACC, which is WACC * Capital. NOPAT - $WACC
Economic Income is NOPAT + Depreciation - Economic Depreciation, where Economic Depreciation is the change in the NPV of a project from one year to the next.
Am I correct that one difference between economic profit and economic income is that the former doesn’t add back deprecation while the latter does?
I’m finding capital bugeting to be tougher than I expected. Those 50 EOC questions are a PITA.
 
icetonez wrote:Did anyone else get tripped up by this the first time through? I didn’t even realize they were different things at first. I guess I need to read/listen more carefully.
Let’s see if I’ve got this now:
Economic profit is the after-tax operating cash flow or NOPAT, which is EBIT (1 - tax rate) less the dollar value weighted average cost of capital or $WACC, which is WACC * Capital. NOPAT - $WACC
Economic Income is NOPAT + Depreciation - Economic Depreciation, where Economic Depreciation is the change in the NPV of a project from one year to the next.
Am I correct that one difference between economic profit and economic income is that the former doesn’t add back deprecation while the latter does?
Click to expand...
If economic income is:
NOPAT + (accounting) depreciation – economic depreciation
and economic profit is:
NOPAT – $WACC
then the difference is:
NOPAT + (accounting) depreciation – economic depreciation – (NOPAT – $WACC)
= [(accounting) depreciation – economic depreciation] + $WACC
The first part is simply adjusting depreciation from the meaningless accounting number to the meaningful economic number, and the second part is financing costs (some explicit, some implicit). So the primary difference is the financing costs, which makes sense: profit is income less expenses. (Indeed, if the true economic depreciation were used on the income statement instead of the nonsense accounting number, the only difference would be financing costs.)
 
Thanks, that’s a great explanation. I also need to remember to add back in interest expense if they give EBT for a levered company. I thought I could get through corporate finance in a week, but it looks like I’ll be spending a few more days here. Anyone else currently working the small middle book?
 
After CFAI beating into us that NPV is the best measure of value, I can’t see the point of economic income. It seems like a meaningless number to me.
The main problem seems to be that Economic depreciation is taken by subtracting the NPVs of the project in two different time periods, which is not something you should do with NPVs.
Though of course, I still need to learn it for the test.
 
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