Question

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 10%. 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)? $41,750,000 $8,450,000 $2,535,000 $39,650,000

Answer 1

1. (All in dollars)

Net sales	80000000
(less)Total operating costs	52000000
Operating income (EBIT)	28000000
(less)Tax	11200000
NOPAT	16800000

NOPAT (Net operating profit after taxes) = Operating income * (1-tax rate) = $28,000,000*(1-40%) = $16,800,000

EVA(Economic value added) = NOPAT - Invested capital*Cost of capital (after tax) = 16,800,000 - 83,500,000*10% = $8,450,000 (2nd option)

2. Expected value of stock = D1/(r-g) r = 10% (Return on equity), g = 5% (growth)

D1 is dividends expected to be paid in next year = Do*(1+growth%) = $3.75*(1+5%) = $3.75*1.05 = $3.9375

Expected value of stock = $3.9375/(10%-5%) = $78.75 (4th option)

3. If r = 12% (instead of 10% earlier)

Expected value of stock = $3.9375/(12%-5%) = $56.25

So Net change = $56.25 - $78.75 = - $22.5 (a decrease of $22.5)