CFA Practice Question

There are 201 practice questions for this study session.

CFA Practice Question

An analyst gathers the following data for a company (all data in $MM):

  • Total assets: $380.
  • Debt: $114.
  • Pretax cost of debt: 5%.
  • Equity (26.6 million shares outstanding): $266.
  • Cost of equity: 14%.
  • EBIT: $45.
  • Marginal tax rate: 40%

The residual income of the company using capital charge method is:
A. -$12.8.
B. -$13.6.
C. -$10.4.
Explanation: To use the capital charge method, we need to calculate WACC first. WACC = Equity share x cost of equity + Debt share x cost of debt x (1 - Tax rate) = (Equity / Total Assets) x cost of equity + (Debt / Total Assets) x cost of debt x (1 - Tax rate) = ($266/$380) x 0.14 + ($114/$380) x 0.05 x (1 - 0.4) = 0.107.

Note that in the calculation of WACC we used after-tax cost of debt, since interest expense is tax-deductible.

After-tax operating income = EBIT x (1 - Tax rate) = $45.0 x (1 - 0.4) = $27.0.

Residual income = After-tax operating income - (Total Assets x WACC) = $27.0 - ($380 x 0.107) = $(13.6).

User Contributed Comments 7

User Comment
Mogensen I don't agree. I think RI should be NI - equity charge. I get -12.3
andrewevelyn The Capital Charge method seems to be what Schweser calls Economic Value Added (EVA):

EVA
= NOPAT - (WACC*invested capital)
= EBIT (1-t) - Dollar WACC.

Does anyone know if they are indeed the same?
danlan2 Andrewevelyn: they are the same
pao13 But Schweser uses another approach for invested capital {(net PP&E + net WC) or (long-term debt + stochholders' equity)}. According to AnalystNotes Invested capital equals Total Assets. Which approach should we use?
volkovv There is a much easier way to solve it.
Residual Income = Net Income - Equity Charge
RI = (EBIT - Interest) * (1 - tax) - (Equity * Cost of Equity)
RI = (45 - 114*.05)*(1 - .4) - (266 * .14) = -13.6
ljamieson I did it volkow's way. Makes more sense. But EVA is in the CFA book too. They don't mention Cap Charge.
MattNYC Capital Charge in the CFA is

NOPAT
Less: Capital Charge (which is MVequity * Kequity)

Be careful. I only took out the taxes part for this question and forgot the Interest.
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