Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 3A

Alternative Measures of Economic Income

Introduction

Capital Cash Flow

Adjusted Present Value

Residual Income

INTRODUCTION

In Chapter 3, we discussed the definition of the commonly defined measures of economic income: net cash flow to common equity capital and net cash flow to invested capital. In Appendix 3A we present alternative definitions of net cash flow and economic income that appear in the literature:

• Capital cash flow
• Adjusted present value
• Residual income

CAPITAL CASH FLOW

An alternative definition of net cash flow to invested capital is capital cash flow.¹ In this formulation the net cash flows include the income tax benefits of the interest expense on debt capital.

(Formula 3A.1)

Net income to common equity (after income taxes)

Plus:	Noncash charges (e.g., depreciation, amortization, changes in deferred revenues, and changes in deferred income taxes)
Minus:	Capital expenditures (amount necessary to support projected revenues and expenses)
Minus:	Additions to net working capital (amount necessary to support projected revenues)
Plus:	Interest expense on long-term debt
Plus:	Dividends on preferred equity capital (if any)
Equals:	Net capital cash flow

or

(Formula 3A.2)

Net cash flow to invested capital

Plus:	Tax deductions resulting from interest as a tax deductible expense
Equals:	Net capital cash flow

When we discount capital cash flow (NCF_c), we use an overall pre-interest-tax-shield cost of capital (or pre-interest-tax-shield ...