- November 17, 2021 at 1:35 pm #640883kirstyqParticipant
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When adding back the net interest costs to NOPAT, why do we not also adjust the retained earnings bf, like we do for non-cash expenses or R&D? I’m specifically looking at chapter 5, example 5 of the P2 lecture notes.
Thanks!December 29, 2021 at 10:13 pm #645030CathParticipant
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Great question & sorry for the delay.
One key consideration for this item is the adjustment of the cost of interest. The cost of interest is included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation and
can be approached in two ways:
Starting with operating profit, then deducting the adjusted tax charge (because tax charge includes the tax benefit of interest). Therefore,
we should multiply the interest by the tax rate and add this to the tax charge; or start with profit after tax and adding back the net cost of interest.
Therefore, we should multiply the interest charge by (1-tax rate).
The reason we do this is that we are using WACC so otherwise we would essentially be deducting interest cost twice
So the accounting adjustments are to remove the distortions that accountants make to the figures.
expenditures on R&D, promotion, and employee training should be capitalised.
Depreciation charge is added back to profit and instead, a charge for economic depreciation is made. This reflects the true change in the
value of assets during the period, unlike accounting depreciation.
Accounts such as provisions, allowances for doubtful debts, deferred tax provisions, and allowances for inventory should be added back to
Non-cash expenses should be added back to profits and to capital employed.
Operating leases should be capitalised and added back to capital employed.
Tax charge will be based on cash taxes, rather than the accruals-based methods used in financial reporting.
So its a cash based profit based calculation based on opening balances.
We want to know, what was the shareholder value before all the accounting
Therefore, we would NOT adjust retained earnings brought forward because we are trying to establish the ‘value added’ for the shareholder.
Hope that explains ok
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