Question

Aires plc was recently formed and issued 80 million £0.50 shares at nominal value and loan notes totalling £24 million. The business used the proceeds from the capital issues to purchase the remaining lease on some commercial properties. Aires plc plans to set up a wholesaling business that is expected to generate an operating profit of £12 million each year. The lease will expire in four years’ time. At the end of the four years, the business will be wound up and the lease will have no residual value.

The required rate of return by investors is 12 per cent.

Required:

Calculate the expected shareholder value generated by the business in each of the four years, using the EVA approach.

Answer 1

EVA stands for ‘Economic value added’ and is a method of evaluating a company’s financial performance. The main concept of EVA is that a company generates ‘value’ only if there is a creation of wealth in terms of returns in excess of its cost of capital invested. So if a company’s EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.

The formula for calculating EVA is as follows:

EVA = Net operating profit after tax – (Capital invested * Weighted average cost of capital)

Facts of the question:

1. Total capital invested by Aires plc:

Particulars	Amount in Million
Shares (80 million @ £ 0.5 per share	£   40
Loan notes	£   24
Total capital invested	£   64

2. Operating profit each year = £12 million
3. Required rate of return = 12%

Assumptions:

• As there are no tax related information is given in the question hence it is assumed that operating profit given is either post tax profit or tax is not applicable
• As weighted average cost of capital is not given in the question hence required rate of return is assumed to be the same.

Calculation of EVA:

Capital invested	Operating profit	Rate of return	EVA
£ 64 million	£ 12 million	12%	= £ 12 million - (£ 64 million*12%) = £ 4.32 million

So for each year the EVA is £4.32 million and hence total EVA for 4 years will be £17.28 million. [£4.32*4].