Question

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 $689,700 $321,300 Total capital employed 4,080,000 3,477,500 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 Creating wealth Jefferson Division Destroying wealth 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

EVA = Net Income(after tax) - Finance Charges
where,Finance Charges = Capital Employed * Cost of Capital
1. Calculation of EVA of Adams Division
Value given
Net Income(after tax)			$689,700
Capital Employed			$4,080,000
Cost of Capital			15%
Finance Charges = $ 4,080,000 * 15%
Finance Charges = $ 612,000
EVA = $ 689,700 - $ 612,000
= $ 77,700
2.Calculation of EVA of Jefferson Division
Value given
Net Income(after tax)			$321,300
Capital Employed			$3,477,500
Cost of Capital			15%
Finance Charges = $ 3,477,500 * 15%
Finance Charges = $ 521,625
EVA = $ 321,300 - $ 521,625
= $ 77,700
= - $ 200,325
3. Conceptual Connection
Any entity whose net income after tax is more than the finance charges paid by
it,would create wealth for its stakeholders.In other words, an entity with a
positive EVA would create wealth for its stake holders and an entity with
negative EVA would destroy the wealth of its stakeholders.
Adams division has a positive EVA,hence it is creating wealth for its stakeholders
Jefferson division has a negative EVA,hence it is destroying wealth of it's
stakeholders.
4.To increase Jefferson division's EVA, Washington's Management
SHOULD
Increase the after tax operating profit that is generated from using the same
amount of capital invested.
In this scenario the cost of capital will remain at $ 521,625 and the Management
would increase the after tax operating profits from the current $ 321,300 to an
amount which is greater than the finance charges of $ 521,625
Continue to generate the same after tax operating profit using the same amount
of capital,but with a lower cost of capital
In this scenario the current cost of capital is 15%.To generate a positive EVA
the finance charges should be less than after tax operating profits. If the cost
of capital is less than 9.24%( since $ 321,300/3,477,525 = 9.24%), Jefferson
division would have a positive EVA because at the same amount of capital
employed,the finance charges would be less than the profits.
SHOULD NOT
Decrease the after tax operating profit that is generated from using the same
amount of capital because in such a scenario the finance charges would remain
the same at $ 521,625 and profits lower than current profit of $ 321,300 would
decrease the EVA which is already negative.
Continue to generate the same after tax operating profit but use more capital to
do so because in such a scenario the finance charges being 15% of the capital
employed would increase from $ 521,625 to a higher amount(since, the capital
employed would be increased from $ 3,477,500 to higher amount) but the after
tax operating profits would remain the same at $ 312,300.This would further
decrease the EVA which is already negative.