Question

Woof Company manufactures toys for dogs. Last year, Woof earned operating income of $310,500 after income taxes. Capital employed equaled $3.7 million. Woof is 30% equity and 70% 10-year bonds paying 6.25 percent interest. Woof’s marginal tax rate is 25 percent. The company is considered a fairly risky investment and probably commands a 12-point premium above the 2.5 percent rate on long-term Treasury bonds. The owner of the company would like to improve EVA. Compute EVA under each of the following independent scenarios the owner is considering.

PART A

Assume no changes are made. Calculate EVA using the original data.

PART B

A different type of plastic will be used in the production of dog toys. This should not affect costs but will begin to affect the market assessment of Woof Company, bringing the premium above long-term Treasury bills to 11 percent the first year. Calculate revised EVA for the first year.

Answer 1

Answer 1
Cost of equity (12%+2.5%)			14.5000%
Cost of debt (6.25%*(1-25%)) (Net of Tax)			4.6875%
WACC
Source	Cost of Source	Weight	Weighted average
Equity	14.5000%	0.3	4.35000%
Debts	4.6875%	0.7	3.28125%
WACC (Weighted average cost of capital)			7.63125%
EVA
Operating income after Tax			310,500.00
Less: cost of Capital employed (3700000*7.63125%)			282,356.25
Economic value added (EVA)			28,143.75
Answer 2
Cost of equity (11%+2.5%)			13.5000%
Cost of debt (6.25%*(1-25%)) (Net of Tax)			4.6875%
WACC
Source	Cost of Source	Weight	Weighted average
Equity	13.5000%	0.3	4.05000%
Debts	4.6875%	0.7	3.28125%
WACC (Weighted average cost of capital)			7.33125%
Revised EVA for the first year
Operating income after Tax			310,500.00
Less: cost of Capital employed (3700000*7.33125%)			271,256.25
Economic value added (EVA)			39,243.75