

By David Harper, (Editor In Chief  Investopedia Advisor)
Contact David
By working through the components of economic profit over the previous chapters, we've been building an economic profit calculation for Disney. Now it's time we pull together these components into the formula to arrive at the final number.
The Formula
As a reminder, here is the basic economic profit calculation:
Economic Profit = NOPAT  Capital Charge (Invested Capital x WACC)
Economic profit is NOPAT minus a capital charge, which represents a sort of rental fee charged to the company for its use of capital. In other words, economic profit is the profits (or returns) our company must generate in order to satisfy the lenders and shareholders who have "rented" capital to the company. Keep in mind that economic profit is a period metric, like earnings or cash flow. In our case, we are referring to Disney's economic profit over the 2004 fiscal year.
The only step that we need to perform before the ultimate economic profit calculation is to estimate the capital charge.
As a reminder, here is the basic economic profit calculation: Economic Profit = NOPAT  Capital Charge (Invested Capital x WACC) Economic profit is minus a capital charge, which represents a sort of rental fee charged to the company for its use of capital. In other words, economic profit is the profits (or returns) our company must generate in order to satisfy the lenders and shareholders who have "rented" capital to the company. Keep in mind that economic profit is a period metric, like earnings or cash flow. In our case, we are referring to Disney's economic profit over the 2004 fiscal year. The only step that we need to perform before the ultimate economic profit calculation is to estimate the capital charge.
Capital Charge Equals Invested Capital Multiplied by WACC
We already calculated invested capital in chapter 4. Now we need to estimate Disney's weighted average cost of capital (WACC). This is the average return expected by the blended investor base. In order to calculate WACC, we need a cost of debt and a cost of equity.
Cost of Debt
The cost of debt can be found on the 10K footnotes. In Disney's case, however, we need to make an estimate because the company relies on several different types of debt. We can make this estimate by looking at its longterm debt rating (at the time of the annual report, Disney's Standard and Poor's longterm debt rating was 'BBB+', which is medium grade). Disney's debt rating corresponds to a debt cost of about 5%. (Note that this will be higher than the riskfree rate since it is a corporate bond with credit risk.)
This 5% rate, however, is a pretax cost of debt  companies can deduct interest expense from their tax bill, and reap a true cash benefit. The aftertax cost of debt is therefore lower. To obtain this number we multiple the pretax cost of debt by the socalled tax shield or (1tax rate). Disney's 2004 effective tax rate is 32%, so the tax shield is 68%, and the aftertax cost of debt equals 5% multiplied by 68%, or 3.4%.
Cost of Equity
Unlike the cost of debt, which is explicit and can be referenced, the cost of equity is implicit: shareholders expect returns on their investment, but unlike interest rates, these returns are neither uniform nor decided or set.
Because of cost of equity's theoretical basis, there are several methods for calculating it. Here we use the capital asset pricing model (CAPM), which is a traditional method but subject to much criticism. In the CAPM, the expected return is a function of one factor only: the presumed risk of the stock as implied by the equity's beta. A higher beta implies greater risk which, in turn, increases the expected return  and the expected return is the same as the cost of equity. (Expected return is simply the view from the investor's perspective while cost of capital is the same number from the company's perspective.)
The CAPM formula says the following:
Cost of Equity = RiskFree Rate + (Beta x Equity Premium)Let's look briefly at the different elements of the equation. Beta, as a measure of risk, is a measure of the stock's sensitivity to the overall market. A beta of 1.0 implies the stock will track closely with the market. A beta greater than 1.0 implies the stock is more volatile than the market. Disney's beta at the end of the fiscal year was 1.15. This implies slightly more risk than the overall market, on both the upside and downside.
The equity premium is the overall average excess return that investors in the stock market expect above that of a riskless investment like U.S. Treasury bonds, which for our calculation is 4%. There is always vigorous debate over what the correct equity premium is (for more on the calculation and debate, see the article series The Equity Risk Premium.) We will use an equity premium of 4%, which is middle of the road as some would argue this is too high and some might argue it is too low.
By using the CAPM formula, we add 4.6% (a 4% equity premium x 1.15 beta) to a riskless rate of 4%. Our estimate for Disney's cost of equity capital therefore equals 8.6%.
The calculations for both Disney's cost of debt and cost of equity are illustrated below in Figure 1:
Figure 1 
Now we can calculate the WACC. To do this, we simply multiply the cost of debt and equity by their respective proportions of invested capital, and then add the two resulting numbers together.
The proportion of debt and equity depends on the total dollar amount of each, and this information we can find on Disney's 2004 balance sheet. If we add up the debt (i.e. longterm debt plus shortterm debt plus other liabilities), we get $17.11 billion. The market value of the equity (market capitalization) is $56.962 billion. Debt is therefore 23% of invested capital and equity is 77%. (Note we used the book value of debt  debt from the balance sheet  but we used the market value of equity. Theoretically, we want the market value of both. But it is much easier to get the book value of debt, and it typically tracks very closely to the market value, so we were satisfied to use book value.)
In Figure 2 below, we multiply each type of cost of capital (calculated in Figure 1) by its respective proportion of total capital. Then we add the two weighted costs together to arrive at WACC.
Figure 2 
The WACC and DebttoEquity Relationship
You may have already noticed that debt is cheaper than equity. There are two reasons for this: first, the pretax cost of debt is lower because it has a prior claim on the company's assets. Second, it enjoys the tax shield (i.e. it is a taxdeductible charge), which is why a balance sheet totally devoid of debt may be suboptimal. Because debt is cheaper, by swapping some equity for debt, a company may be able to reduce its WACC.
So why not swap all equity for debt? Well, that would be too risky; a company must service its debt, and a greater share of debt increases the risk of default and/or bankruptcy. In Figure 3 below, we graph estimates of WACC for Disney at different debttoequity ratios. At a debttoequity ratio of 0.9, the graph plots a minimum value. In theory, this would be Disney's optimal capital structure because it minimizes their cost of capital  after 0.9, higher ratios begin to produce a higher WACC. But, this is merely theoretical and depends on our assumptions.
Figure 3 
The Economic Profit Calculation
We now have all of the elements to perform the final economic profit calculation, which is the subtraction of a capital charge from NOPAT. The capital charge is invested capital multiplied by WACC (a percentage). This is all shown below in Figure 4:
Figure 4 (numbers in millions) 
The economic profit number tells us that, despite generating $3.597 billion in aftertax net operating profits, Disney did not quite cover its cost of capital. Of course, it fully serviced its debt, but the point of economic profit is to charge the company for the use of equity capital â€“ when we incorporate this cost, we find that Disney lost (some would say "destroyed value") $765 million in economic profit over the year.
Summary
In this installment, we performed the final economic profit calculation, pulling together the components we explored and calculated throughout this tutorial. We started with NOPAT (calculated in chapter 3). Then we estimated invested capital (chapter 4). In this chapter we then estimated the capital charge by multiplying invested capital by the weighted average cost of capital. Finally, we subtracted the capital charge from NOPAT in order to get economic profit over the oneyear period.
EVA: What Does It Really Mean?

Investing
Investors Need A Good WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality. 
Investing
Disney Stock: Capital Structure Analysis (DIS)
Learn about Disney's capital structure and why the company can afford to be more aggressive with its current level of debt exposure. 
Small Business
Explaining Cost Of Capital
Cost of capital is the cost of funds used to finance a business. 
Investing
Evaluating a Company's Capital Structure
Learn to use the composition of debt and equity to evaluate balance sheet strength. 
Investing
How to Calculate Required Rate of Return
The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it. 
Personal Finance
Top Things to Know For an Investment Banking Interview
Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare. 
Managing Wealth
Weighted Average Cost Of Capital (WACC)
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality