Question

Rafael, your newly appointed boss, has tasked you with evaluating the following financial data for Allied Biscuit Co. to determine how Allied Biscuit’s value has changed over the past year. The investment firm for which you work will make a positive (or “buy”) recommendation to its investing clients if Allied Biscuit’s value has increased over the past year, a neutral (or “hold”) recommendation if the value has remained constant, or a negative (or “sell”) recommendation if the value has decreased. He has recommended that you use several metrics to ascertain how the firm’s value has changed, and he has provided you with the following income statement and balance sheet. Allied Biscuit Co. Income Statement January 1 - December 31, Year 2 Year 2 Year 1 Sales $8,400,000 $8,000,000 Expenses11 6,720,000 6,560,000 EBITDA $1,680,000 $1,440,000 Depreciation and amortization expense 294,000 280,000 EBIT $1,386,000 $1,160,000 Interest expense 252,000 200,000 EBT $1,134,000 $960,000 Tax expense (40%) 453,600 384,000 Net income $680,400 $576,000 Common dividends $408,240 $345,600 Addition to retained earnings $272,160 $230,400 11 Excludes depreciation and amortization Allied Biscuit Co. Balance Sheet December 31, Year 2 Assets: Year 2 Year 1 Cash and cash equivalents $638,400 $456,000 Receivables 2,128,000 1,520,000 Inventory 3,724,000 2,660,000 Current assets $6,490,400 $4,636,000 Net fixed assets 4,149,600 2,964,000 Total current assets $10,640,000 $7,600,000 Liabilities and Equity: Accounts payable $1,596,000 $1,140,000 Accruals 1,037,400 741,000 Notes payable 2,234,400 1,596,000 Total current liabilities $4,867,800 $3,477,000 Long-term debt 2,048,200 1,463,000 Total liabilities $6,916,000 $4,940,000 Common stock ($1 par) 744,800 532,000 Retained earnings 2,979,200 2,128,000 Total equity $3,724,000 $2,660,000 Total liabilities and equity $10,640,000 $7,600,000 Shares outstanding 744,800 532,000 Weighted average cost of capital 7.98% 7.30% To facilitate your analysis, complete the following table, and use the results to answer the related questions. (Note: Round all percentage change answers to two decimal places. If a dollar value is below $100, round your answer to two decimal places. If your answer is negative use a minus (-) sign.) Company Growth and Performance Metrics Metric Year 2 Year 1 Percentage Change General Metrics Sales $8,400,000 $8,000,000 % Net income $680,400 $576,000 % Net cash flow (NCF) $ $856,000 % Net operating working capital (NOWC) $3,857,000 $ % Earnings per share (EPS) $ $1.08 % Dividends per share (DPS) $0.55 $ % Book value per share (BVPS) $ $5.00 0.00% Cash flow per share (CFPS) $ $ -18.63% Market price per share $21.73 $19.75 % MVA Calculation Market value of equity $ $ 54.04% Book value of equity $3,724,000 $2,660,000 % Market Value Added (MVA) $ $7,847,000 % EVA Calculation Net operating profit after-tax (NOPAT) $831,600 $ % Investor-supplied operating capital $ $ 40.00% Weighted average cost of capital 7.98% 7.30% Dollar cost of capital $ $ 53.04% Return on invested capital (ROIC) % % -14.63% Economic Value Added (EVA) $192,959 $ % Points: Using the change in Allied Biscuit’s EVA as the decision criterion, which type of investment recommendation should you make to your clients? A buy recommendation A hold recommendation A sell recommendation Points: Which of the following statements are correct? Check all that apply. For any given year, one way to compute Allied Biscuit’s EVA is as the difference between its NOPAT and the product of its operating capital and its weighted average cost of capital. An increase in the number of common shares outstanding must increase the market value of the firm’s equity. Other things remaining constant, Allied Biscuit’s EVA will increase when its ROIC exceeds its WACC. Allied Biscuit’s net income is growing at a rate greater than its sales. This could imply that either its revenues are growing more quickly than its expenses or that management is being effective in managing its costs while achieving the reported growth in sales. Other things remaining constant, either event should increase the value of the firm. Allied Biscuit’s NCF is calculated by adding its annual interest expense to the corresponding year’s net income.

Answer 1

1.

	Formula	Year 2	Year 1	%age change
Sales		84,00,000	80,00,000	5.00%
Net income		6,80,400	5,76,000	18.13%
Net cash flow (NCF)	Net income + Depreciation	9,74,400	8,56,000	13.83%
Net operating working capital (NOWC)	Current assets - A/C payable - Accruals	38,57,000	27,55,000	40.00%
Earnings per share (EPS)	Net income/Shares O/S	0.91	1.08	-15.41%
Dividends per share (DPS)	Common dividends/Shares O/S	0.55	0.65	-15.34%
Book value per share (BVPS)	Total equity/Shares O/S	5	5	0.00%
Cash flow per share (CFPS)	NCF/Shares O/S	1.31	1.61	-18.63%
Market price per share		21.73	19.75	10.03%
MVA calculation
Market value of equity (MV)	BV + MVA	1,61,84,983	1,05,07,000	54.04%
Book value of equity (BV)		37,24,000	26,60,000	40.00%
Market Value Added (MVA)	MV - BV	1,24,60,983	78,47,000	58.80%
EVA calculation
NOPAT	EBIT*(1-Tax rate)	8,31,600	6,96,000	19.48%
Investor-supplied operating capital	NOWC + Net fixed assets	80,06,600	57,19,000	40.00%
WACC		7.98%	7.30%
Dollar cost of capital	WACC*(Total equity + Notes payable + L-T debt)	638927	417487	53.04%
ROIC	NOPAT/Investor-supplied operating capital	10.39%	12.17%	-14.63%
EVA calculation	NOPAT - (WACC*Investor-supplied operating capital)	1,92,959	278513	-30.72%

2. If EVA is used as a criteria then a sell recommendation should be made as its EVA is decreasing from Year 1 to Year 2.

3. Statement 1 is true - EVA is calculated as NOPAT - (WACC*investor-supplied operating capital)

Statement 2 is false - Number of shares is irrelevant to the determination of market value of equity

Statement 3 is true - If ROIC is greater than WACC then its EVA will increase as the company will be creating value over and above the invested capital.

Statement 4 is true - Other things being constant, increase in sales or net income will increase the firm value as it will generate additional profit for the firm.

Statement 5 is false - NCF is calculated as Net income plus depreciation.