Question

Question 1.

1. Suppose 1 year T-Bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk of return?
2. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 5 year treasury security, assuming the pure expectations theory is valid?

Question 2.

For 2015, Everyday Electronics reported $22.5 million of sales and $18 million of operating costs (including depreciation). The company has $15 million of total invested capital. Its after-tax cost of capital is 9%, and its federal-plus-state income tax rate was 35%. What was the firm’s economic value added (EVA), That is, how much value did management add to stockholders wealth during 2015?

Answer 1

Que 1) According to Fisher equation (1+Nominal Interest rate) = (1+real Interest rate)(1+Inflation rate) Here the nominal rate = 7% Inflation = 3.20% (1+0.07) = (1+real rate)*(1+0.032) Real rate= 1.07/1.032-1 0.036822 3.68% Assuming pure expectation theory is valid, the expected return would be the expected rate of return = risk free rate + Inflation expectation 2.5%+4.1% 6.6 %

Que 2) EVA = EBIT*(1- Tax rate) - (Total Invested capital * WACC) (Millions) 22.5 Sales Operating Cost EBIT 4.5 Tax rate 35% Total Invested capital = 15 Million WACC 9% EVA 4.5*(1-0.35) - 15*0.09 1.575 Million