Question

Calculating EVA

Brewster Company manufactures elderberry wine. Last year, Brewster earned operating income of $186,000 after income taxes. Capital employed equaled $2.7 million. Brewster is 40 percent equity and 60 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 5 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.

$

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	$
Year 2	$

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 $3,700,000. The new after-tax operating income would be $400,000. Using the original data, calculate EVA. Then, recalculate EVA assuming the materials substitution described in Requirement 2. New after-tax income will be $400,000, 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	$
Year 1 (10% premium)	$
Year 2 (7% premium)	$

Answer 1

Answer -2 WACC Proportion Rate of return Debt Rate Post Tax debt rate 22% (12%+10%) 8.80%(.4*17%) 2.16%|(.6*3.6%) 10.96% WACC Equity Debts Year -1 0.40 6% 0.60 3.60% Proportion Debt Rate Rate of return Post Tax debt rate 19%|(12%+7%) Equity Debts 7.60% (.4*17%) 2.16% (.6*3.6%) 9.76% WACC Year -2 0.40 6% 3.60% 0.60 -109920 (186000-(2700000*10.96%) EVA is EVA is -77520 (186000-(2700000*9.76%))

Operating Income after Tax i.e Capital employed Equity 1,86,000.00 27,00,000.00 40% 60% 10 year bond Risk Premium 12% 5% Long germ Treasury Bond rate The formula for calculating EVA is: Net Operating Profit After Taxes (NOPAT) Invested Capital* Weighted Average Cost of Capital (WACC) Answer-1 WACC Proportion Rate of return Debt Rate Post Tax debt rate Equity Debts 17% (12%+5%) 6.80%|(.4*17%) 3.60% 2.16% (.6*3.6%) 0.40 6% 0.60 8.96% WACC -55,920.00 (186000-(2700000*8.96%) EVA is

Answer-3 (a) Operating Income after Tax i.e Capital employed 4,00,000 37,00,000 Equity 80% 20% 10 year bond Risk Premium 12% 5% Long germ Treasury Bond rate WACC Proportion Rate of return Debt Rate Post Tax debt rate 13.60% (.4*17%) 3.60% 0.72% (.6*3.6%) 17% (12%+5%) Equity Debts 0.80 6% 0.20 14.32% WACC -1,29,840.00 (400000-(3700000*14.32%) EVA is Recalculate EVA assuming the materials substitution WACC Post Tax debt rate ortion Rate of return Debt Rate Equity Year -1 22% (12%+10%) 17.60% (.4*17%) 0.80 0.72%(.6*3.6%) 18.32% WACC 6% 3.60% Debts 0.20 Proportion Post Tax debt rate Rate of return Debt Rate 19% (12%+7%) 15.20% (.4*17%) 0.72% (.6*3.6%) 15.92% WACC Equity Debts Year -2 0.80 6% 3.60% 0.20 EVA is 277840 400000-(3700000*18.32%) -189040 400000-(3700000*15.92%) EVA is