Question

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Brewster Company manufactures elderberry wine. Last year, Brewster earned operating income of $195,000 after income taxes....

Brewster Company manufactures elderberry wine. Last year, Brewster earned operating income of $195,000 after income taxes. Capital employed equaled $2.9 million. Brewster is 45 percent equity and 55 percent 10-year bonds paying 6 percent interest. Brewster’s marginal tax rate is 40 percent. The company is considered a fairly risky investment and probably commands a 13-point premium above the 5 percent rate on long-term Treasury bonds.

Jonathan Brewster’s aunts, Abby and Martha, have just retired, and Brewster is the new CEO of Brewster Company. He would like to improve EVA for the company. Compute EVA under each of the following independent scenarios that Brewster is considering.

Required:

Use a spreadsheet to perform your calculations and round all interim and percentage figures to four decimal places. If the EVA is negative, enter your answer as a negative amount.

1. No changes are made; calculate EVA using the original data.

$

2. Sugar will be used to replace another natural ingredient (atomic number 33) in the elderberry wine. This should not affect costs but will begin to affect the market assessment of Brewster Company, bringing the premium above long-term Treasury bills to 11 percent the first year and 8 percent the second year. Calculate revised EVA for both years.

EVA
Year 1 $
Year 2 $

3. Brewster is considering expanding but needs additional capital. The company could borrow money, but it is considering selling more common stock, which would increase equity to 80 percent of total financing. Total capital employed would be $3,700,000. The new after-tax operating income would be $395,000. Using the original data, calculate EVA. Then, recalculate EVA assuming the materials substitution described in Requirement 2. New after-tax income will be $395,000, and in Year 1, the premium will be 11 percent above the long-term Treasury rate. In Year 2, it will be 8 percent above the long-term Treasury rate. (Hint: You will calculate three EVAs for this requirement.)

EVA
Year 1 $
Year 1 (11% premium) $
Year 2 (8% premium) $

Solutions

Expert Solution

EVA is Economic Value added. It is computed as Net operating profit after taxes less the cost of Capital. If EVA is negative, it means that the investors are not even able to recover the cost of the capital from the business. Although the cost of equity is notional but it denotes the alternate avenues available to the investor to earn a return on his investment.

1. EVA = - $ 525,600.0000 (Refer Spreadsheet for more details)

2. Year 1 EVA = -$109,500.0000

Year 2 EVA = -$70,350.0000

3. With additional Equity investment, the Debt reduces to $740,000 whereas the equity investment increases to $2960,000.0000

EVA consider equity cost @18% p.a = -$182,200.0000

EVA considering equity cost @16% p.a.= - $123,000.0000

EVA considering equity cost @13% p.a = - $34,200.0000

For detailed excel spreadsheet working please find the below table:

EVA = Economic Value Added
NOPAT = $195,000.0000
Debt = $1,595,000.0000
Equity = $1,305,000.0000
Cost of Debt = 6%
Cost of Equity = 18%
WACC = $330,600.0000
EVA = ($135,600.0000)
2. Computation of EVA when cost of Equity in year 1 is 16% and 13% respectively, assuming NOPAT remains the same.
Year 1 WACC = $304,500.0000
Year 2 WACC = $265,350.0000
Year 1 EVA = ($109,500.0000)
Year 2 EVA = ($70,350.0000)
3. Computation of EVA with additional equity investment
NOPAT = $395,000.0000
Debt = $740,000.0000
Equity = $2,960,000.0000
Cost of Debt = 6%
Cost of Equity Year 1= 18%
Cost of Equity Year 1= 16%
Cost of Equity Year 2 = 13%
WACC in Year 1 $577,200.0000
WACC in Year 1 $518,000.0000
WACC in Year 2 $429,200.0000
EVA - Year 1 ($182,200.0000)
EVA - Year 1 ($123,000.0000)
EVA - Year 2 ($34,200.0000)

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