Question

Financial statements reflect only book values of the data that analysts use to evaluate a company’s performance. To determine if a firm’s earnings, after taxes but before the payment of interest and dividends, are sufficient to compensate both the firm’s bondholders and shareholders, Stern Stewart Management Services developed an analytical technique called economic value added (EVA). EVA effectively measures the amount of shareholder wealth that the firm’s management has added to the value of the firm during a period of time. If EVA is positive, then management has added value, while a negative value indicates that the firm’s managers reduced the firm’s value and shareholders might have earned more value by investing in some other investment with the same level of risk.

Consider this case: Last year, Jackson Tires reported net sales of $80,000,000 and total operating costs (including depreciation) of $52,000,000. Jackson Tires has $83,500,000 of investor-supplied capital, which has an after-tax cost of 12.5%. If Jackson Tires’s tax rate is 40%, how much value did its management create or lose for the firm during the year (rounded to the nearest whole dollar)? $6,362,500 $37,562,500 $1,749,688 $39,662,500

Answer 1

Answer:

Economic Value Added(EVA)= Net Operating Profit After Taxes (NOPAT)-Invested Capital *WACC

Again: NOPAT= Earnings before Interest and Taxes(EBIT)*(1- Tax Rate)

Again: EBIT= Net Sales-Operating Expenses-Depreciation

As given in the question: Net Sales= $ 80,000,000 and Operating Expenses Including Depreciation= $52,000,000, putting these values into the formula for EBIT we get;EBIT= $ 80,000,000-$52,000,000 ie. $28,000,000

Putting the value of EBIT and tax rate of 40% or .4 in the formula for NOPAT we get:

NOPAT= $28,000,000*(1-.4) ie. $16,800,000

Again as given in the question: Invested capital = $ 83,500,000 and WACC= 12.5% or .125, using these values and the value of NOPAT in the formula for Economic Value Added we get:Economic Value Added= $16,800,000-($ 83,500,000*.125) ie. $ 6,362,500.Since EVA is positive so the company has added a value of: $ 6,362,500.

Hence: option (A) is the correct answer.