Question

Value added to a firm

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)?

You have taken a job as an entry-level analyst, and your boss has asked you to find the expected value of Adams Furniture’s stock. As you were doing your research, you found out that Adams Furniture just paid a dividend (D0D0) of $3.75. The firm has experienced consistent growth of 7% for the last couple of years, and you believe that the firm will continue to grow at the same rate in the future.

If investors require a return of 10% on Adams Furniture’s stock, what is the expected value of the company’s stock?

Answer 1

	A	Net Sales	$80,000,000
	B	Total operating costs	$52,000,000
	C=A-B	Operating Income before tax	$28,000,000
	D=C*40%	Tax expenses	$11,200,000
	E=C-D	Net Operating Income	$16,800,000
	F	Investor supplied capital	$83,500,000
	G	After tax cost of investor capital	12.50%
	H=F*G	Total cost of capital	$10,437,500
	I=E-H	Economic Value added	$6,362,500
		Value Created by management	$6,362,500
	g	Expected Constant Growth rate=7%	0.07
	D1=3.75*(1+g)	Expected dividend next year	$4.01	(3.75*1.07)
	R	Required rate of return=10%	0.1
		Expected value of stock=Present value of future dividends
	P0=D1/(R-g)	Expected value of stock=	$133.75	(4.01/(0.1-0.07)
		Expected value of the company’s stock	$133.75