316 Part Three Best Practices in Capital Budgeting
bre44380_ch12_302-326.indd 316 09/11/15 07:55 AM
The regional manager is getting conflicting signals. On the one hand, he is told to find
and propose good investment projects. Good is defined by discounted cash flow. On the other
hand, he is also urged to seek high book income. But the two goals conflict because book
income does not measure true income. The greater the pressure for immediate book profits,
the more the regional manager is tempted to forgo good investments or to favor quick payback
projects over longer-lived projects, even if the latter have higher NPVs.Measuring Economic Profitability
Let us think for a moment about how profitability should be measured in principle. It is easy
enough to compute the true, or economic, rate of return for a common stock that is continu-
ously traded. We just record cash receipts (dividends) for the year, add the change in price
over the year, and divide by the beginning price:Rate of return =cash receipts + change in price
_________________________
beginning price=C 1 + (P 1 − P 0 )
_____________
P 0
The numerator of the expression for rate of return (cash flow plus change in value) is called
economic income:Economic income = cash flow + change in present valueAny reduction in present value represents economic depreciation; any increase in present
value represents negative economic depreciation. ThereforeEconomic income = cash flow − economic depreciationThe concept works for any asset. Rate of return equals cash flow plus change in value
divided by starting value:Rate of return =C 1 + (PV 1 − PV 0 )
_______________
PV 0
where PV 0 and PV 1 indicate the present values of the business at the ends of years 0 and 1.
The only hard part in measuring economic income is calculating present value. You can
observe market value if the asset is actively traded, but few plants, divisions, or capital projects❱ TABLE 12.2
Forecasted book
income, ROI, and
EVA for the proposed
Nodhead store. Book
ROI and EVA are
underestimated for
the first two years
and overestimated
thereafter.
Note: There are minor rounding
errors in some annual figures.Cash flowBook ROI
EVABook depreciation
Book incomeBook value at start of year
Book value at end of year18341,00010026721671672 0.06766783420033
0.040
25016750066725083
0.125
17167333500298131
0.263
81167167333298131
0.394
981670167297130
0.782
11416723456Year