Question

Economic Value Added Washington Company has two divisions: the Adams Division and the Jefferson Division. The following information pertains to last year's results: Adams Division Jefferson Division Net (after-tax) income $677,600 $324,450 Total capital employed 4,760,000 3,282,500 Washington's actual cost of capital was 15%. Required: 1. Calculate the EVA for the Adams Division. If required, enter a negative EVA as a negative number by entering your answer with the minus sign. $ 2. Calculate the EVA for the Jefferson Division. If required, enter a negative EVA as a negative number by entering your answer with the minus sign. $ 3. Conceptual Connection: Is each division creating or destroying wealth? Adams Division Jefferson Division 4. Describe generally the types of actions that Washington’s management team could take to increase Jefferson Division’s EVA? Increase the after-tax operating profit that is generated from using the same amount of invested capital. Continue to generate the same after-tax operating profit but use less capital to do so. Continue to generate the same after-tax operating profit using the same amount of capital, but with a lower cost of capital. Decrease the after-tax operating profit that is generated from using the same amount of invested capital. Continue to generate the same after-tax operating profit but use more capital to do so.

Answer 1

Solution:

1. EVA for Adams Division

EVA = Net operating income after tax - (capital employed *WACC)

= 677600 – 4760000 * 15%

= -$36400

1. EVA for Jefferson Division

EVA = Net operating income after tax - (capital employed *WACC)

            = 324450 – 3282500* 15%

            = - $167,925

1. Both the division are having negative Economic Value Added. The profits generated by both the divisions are less than the cost of capital employed in the respective division. As such, it can be said that both the divisions are resulting in destroying the wealth.
2. Steps that can be taken to increase the profits of Jefferson Division:
   1. Reduction in costs: the management can look into the costs of the division and necessary steps such as purchasing raw material in bulk, reviewing the operations of the division (so that employees can be utilized more efficiently), exploring opportunities like forward or backward integration. Such Steps can reduce the costs and increase the profits of the division.
   2. Increase in Sales: Division’s sales can be increased by taking steps such as better marketing strategies, reducing price / increasing quality of the product by analyzing customer needs and studying market for substitute products
      1. Increase the after-tax operating profit that is generated from using the same amount of invested capital

Capital invested in Jefferson division: = Capital invested * WACC

                                                          = 3282500 * 15% = $492,375

(amount of operating profits that are required to be generated)

1. Continue to generate the same after-tax operating profit but use less capital to do so.

EVA = Net operating income after tax - (capital employed *WACC)

Let EVA be ‘0’ so as to calculate the amount of capital required for operating profits of Rs. $324,450

0 = 324450 – (CE * 15%)

0.15CE = 324450

Capital employed = 2163000

1. Continue to generate the same after-tax operating profit using the same amount of capital, but with a lower cost of capital.

EVA = Net operating income after tax - (capital employed *WACC)

Let EVA be ‘0’ so as to calculate the amount of Cost of capital for operating profits of Rs. $324,450

0 = 324450 – (3282500 * WACC)

WACC = 324450 / 3282500 = 9.88%