Question

2. Chapter 12 Problem Set 22 - EVA Ohio Building Products (OBP) is considering the launch of a new product that would require an initial investment in equipment of $30,800 (no investment in working capital is required). The forecast profits from the product are as follows: Net revenues Depreciation Pretax profit Tax at 35% Net profit Year 1 Year 2 $23,337 $22, 152 13,860 16,940 9,477 5,212 3,317 1,824 $6,160 $3,388 No cash flows are forecast after year 2, and the equipment will have no salvage value. The cost of capital is 10%. a. What is the project's NPV? uge 2 of 2 2019/20 Semester 1 b. Calculate the expected EVA and the return on investment in each of years 1 and 2. c. Why does EVA decline between years 1 and 2, whereas the return on investment is unchanged? d. Calculate the present value of the economic value added. How does this figure compare with the project NPV? e. What would be the return on investment and EVA if OBP chooses instead to depreciate the investment straight line? Do you think that this would provide a better standard for measuring subsequent performance?

Ohio Building Products (OBP) is considering the launch of a new product that would require an initial investment in equipment of $30,800 (no investment in working capital is required). The forecast profits from the product are as follows:

	Year1	Year2
Net revenues	$23,337	$22,152
Depreciation	13,860	16,940
Pretax profit	9,477	5,212
Tax at 35%	3,317	1,824
Net profit	$6,160	$3,388

No cash flows are forecast after year 2, and the equipment will have no salvage value. The cost of capital is 10%.
a. What is the project’s NPV?

b. Calculate the expected EVA and the return on investment in each of years 1 and 2.

c. Why does EVA decline between years 1 and 2, whereas the return on investment is unchanged?

d. Calculate the present value of the economic value added. How does this figure compare with the project NPV?

e. What would be the return on investment and EVA if OBP chooses instead to depreciate the investment straight line? Do you think that this would provide a better standard for measuring subsequent performance?

(I got the answer for other parts, only need the answer for questions in BOLD.)

Answer 1

Answer to Part C-

Formula for EVA is Net Operating Profit after Tax (NOPAT) - (Invested Capital * Weighted Average Cost of Capital)

NOPAT for year 1 = 6160 (Since there is not Interest)

Invested Capital = 30800

Cost of Capital = 10%

Applying the above mentioned formula for EVA for year 1 is =

6160 - (30800*10%) which is equal to 3080

Value of Asset at the end of year 1 = Value of Asset at the beginning of the year - Depriciation for the year

Value of the Asset at the end of year 1 = 30800-13860= 16940

Applying the same formula in year 2 for calculation of EVA

NOPAT= 3388

Invested Capital= 16940

Cost of Capital= 10%

EVA= 3388 - (16940*10%) = 1694

ROI whereas is constant at 20% (6160/30800 and 3388/16940)

The main reason as to why EVA is declining and ROI is constant is because EVA represents the additional gain over the expected return from the Investor. Here the Investor has a cost of capital of 10% but he is getting a ROI of 20% so the Economic value added is actually the extra 10% that he is gaining above his expected cost on the Capital. To add to the above mentioned point the EVA was also lower due to  Higher depriciation and Lower Sales in year 2. These 2 things played a negative effect on Profits and lead to a fall in EVA year on year.

So to Summarise EVA was lower in the second year and ROI constant was because of Higher Depriciation and Lower Sales in Year 2 and because it showcases additional value generated over and above our ROI.

Answer to Part E-

If we start applying a Straight Line method for calculation of EVA and ROI we will see that in this case we get both Higher in year 2 as compared to year 1. When we apply a Straight Line method the value of the assets falls at a constant pace over its life and until and unless the Revenue is not declining at a high rate to the Asset the ROI and EVA will always be higher than the previous year giving us a better standard for measuring performance. Anything that stays constant helps us to estimate better in the future since we do not have to make our own assumptions for it. And lesser the assumptions better will be our measurement.