Question

Calculating EVA

Brewster Company manufactures elderberry wine. Last year, Brewster earned operating income of $189,000 after income taxes. Capital employed equaled $2.8 million. Brewster is 45 percent equity and 55 percent 10-year bonds paying 6 percent interest. Brewster’s marginal tax rate is 40 percent. The company is considered a fairly risky investment and probably commands a 12-point premium above the 4 percent rate on long-term Treasury bonds.

Jonathan Brewster’s aunts, Abby and Martha, have just retired, and Brewster is the new CEO of Brewster Company. He would like to improve EVA for the company. Compute EVA under each of the following independent scenarios that Brewster is considering.

Required:

Use a spreadsheet to perform your calculations and round all interim and percentage figures to four decimal places. If the EVA is negative, enter your answer as a negative amount.

1. No changes are made; calculate EVA using the original data.

$ fill in the blank 1

2. Sugar will be used to replace another natural ingredient (atomic number 33) in the elderberry wine. This should not affect costs but will begin to affect the market assessment of Brewster Company, bringing the premium above long-term Treasury bills to 10 percent the first year and 7 percent the second year. Calculate revised EVA for both years.

	EVA
Year 1	$ fill in the blank 2
Year 2	$ fill in the blank 3

3. Brewster is considering expanding but needs additional capital. The company could borrow money, but it is considering selling more common stock, which would increase equity to 80 percent of total financing. Total capital employed would be $3,500,000. The new after-tax operating income would be $380,000. Using the original data, calculate EVA. Then, recalculate EVA assuming the materials substitution described in Requirement 2. New after-tax income will be $380,000, and in Year 1, the premium will be 10 percent above the long-term Treasury rate. In Year 2, it will be 7 percent above the long-term Treasury rate. (Hint: You will calculate three EVAs for this requirement.)

	EVA
Year 1	$ fill in the blank 4
Year 1 (10% premium)	$ fill in the blank 5
Year 2 (7% premium)	$ fill in the blank 6

Answer 1

SOLUTION:

Operating Income after Taxes = $ 189,000

Capital Employed = $ 2,800,000

Cost of Bond = 6%*(1-40%) = 3.6000%

Cost of Equity = 12-point premium above the 4 percent rate on long-term Treasury bonds = 12% + 4% = 16.0000%

WACC = (3.600% * 55%) + (16%* 45%)

= 1.9800 + 7.2000

= 9.1800%

1. EVA using the original data:

EVA = Operating Income after Tax - (WACC * Capital Employed)

= $189,000 - (9.1800% * $ 2,800,000)

= $189,000 - 257,040

= - $ 68,040.0000

2.

	EVA
YEAR 1 (10% PREMIUM)	-42,840
YEAR 2 (7% PREMIUM)	-5,040

Revised Cost of Equity for year 1 = 10-point premium above the 4 percent rate on long-term Treasury bonds

= 10% + 4%

= 14.0000%

Revised WACC for year 1 = (3.600% * 55%) + (14%* 45%)

= 1.9800 + 6.3000

= 8.2800%

Revised EVA for year 1 = Operating Income after Tax - WACC * Capital Employed

= $189,000 - (8.2800% * $ 2,800,000)

= $ 189,000 - $ 231,840

= - $ 42,840.0000

Revised Cost of Equity for year 2 = 7-point premium above the 4 percent rate on long-term Treasury bonds

= 7% + 4%

= 11.0000%

Revised WACC for year 2 = (3.600% * 55%) + (11%* 45%)

= 1.9800 + 4.95

= 6.9300%

Revised EVA for year 2 = Operating Income after Tax - WACC * Capital Employed

= $189,000 - (6.9300% * $ 2,800,000)

= $189,000 - $194,040

= - $ 5,040.0000

3.

	EVA
YEAR 1	-93,200
YEAR 1 (10% PREMIUM)	-37,200
YEAR 2 (7% PREMIUM)	+46,800

New Operating Income after Taxes = $ 380,000

Capital Employed = $ 3,500,000

Cost of Bond = 6%*(1-40%) = 3.6000%

Cost of Equity = 12-point premium above the 4 percent rate on long-term Treasury bonds = 12% + 4% = 16.0000%

WACC = (3.600% * 20%) + (16%* 80%)

= 0.7200 + 12.8000

= 13.5200%

EVA = Operating Income after Tax - (WACC * Capital Employed)

= $380,000 - (13.5200% * $ 3,500,000)

= $380,000 - 473,200

= - $ 93,200.0000

Revised Cost of Equity for year 1 = 10-point premium above the 4 percent rate on long-term Treasury bonds

= 10% + 4%

= 14.0000%

Revised WACC for year 1 = (3.600% * 20%) + (14%* 80%)

= 0.7200 + 11.2000

= 11.9200%

Revised EVA for year 1 = Operating Income after Tax - WACC * Capital Employed

= $380,000 - (11.9200% * $ 3,500,000)

= $380,000 - $ 417,200

= - $ 37,200.0000

Revised Cost of Equity for year 2 = 7-point premium above the 4 percent rate on long-term Treasury bonds

= 7% + 4%

= 11.0000%

Revised WACC for year 2 = (3.600% * 20%) + (11%* 80%)

= 0.7200 + 8.8000

= 9.5200%

Revised EVA for year 2 = Operating Income after Tax - WACC * Capital Employed

= $380,000 - (9.5200% * $ 3,500,000)

= $380,000 - $333,200

= + $ 46,800.0000