Question

Because New Market Products (NMP) markets consumer staples, it is able to make use of considerable debt in its capital structure; specifically, 90 percent of the company’s total assets of $450,000,000 are financed with debt capital. Its cost of debt is 8 percent before taxes, and its cost of equity capital is 12 percent. NMP achieved a pre-tax income of $ 5.1 million in 2006 and had a tax rate of 40 percent. What was NMP’s residual income?

Answer 1

Answer:

WACC Calcutaion:

Debt as % of total asset = 90%

Equity as % of total assets = 100% - 90% = 10%

WACC = Cost of equity * weight of equity + before tax cost of debt * (1 - tax rate) * weight of debt

= 12% * 10% + 8% *(1 - 40%)*90%

= 5.52%

NOPAT:

Pretax Income = $5.1 million = $5,100,000

Interest expense = 450000000 * 90% * 8% = $32,400,000

Operating income = Pretax income + Interest expense = 5100000 + 32,400,000 = $37,500,000

NOPAT = 37500000 * (1 - 40%) = $22,500,000

RESIDUAL INCOME:

Residual income = NPOAT - Capital charge = 22500000 * 450000000 * 5.52% = - $2,340,000 or ($2,340,000)

Residual income = ($2,340,000)

[alternately it can also be calculated as : Residual income = Pretax income *(1 - tax rate) - Equity charge = 5100000 * (1 - 40%) - 450000000*10%*12% = ($2,340,000)]