Question

Question 2 Axis company is a very small company in terms of market capitalisation. The information about this company is given below: Total assets = $200000 Current assets = $45000 Half of the investment is financed by liability and the rest is financed by equity Cost of equity = 12% Cost of debt = 6% Tax rate = 30% Earning before interest and tax = $250000 a) Calculate the capital charge. b) Calculate the equity charge c) Calculate the economic value added (EVA) d) Compare the EVA with the net income of the company and what does it indicate to a management accountant? [20 marks 1

Answer 1

a) Capital Charge Formula = Capital * cost of capital Cost of equity Weight of equity Cost of debt Weight of debt Tax Rate 12% 50% 6% 50% 30% Cost of capital 8.10% Formula for cost of capital = (Cost of equity * Weight of equity) + (Cost of debt(1-Tax Rate) * Weight of debt) Capital charge $16,200.00 b) Equity Charge Formula = Equity capital * Cost of capital Total Assets Current Assets Weight of equity Weight of debt $2,00,000.00 $45,000.00 50% 50% deac ewad Equity Capital Debt $1,00,000.00 $1,00,000.00 Equity Charge $8,100.00

c) Economic value added (EVA) Formula = Net operating profit after tax - Capital Charge Formula for Net operating profit after tax = Earning before interest and taxes - Taxes) f hef*g Earning before interest and taxes Taxes @30% Net Operating profit after taxes Capital Charge Economic value added $2,50,000.00 $75,000.00 $1,75,000.00 $16,200.00 $1,58,800.00 jhi

d) Comparision Earning before interest and taxes Interest Earning before taxes Tax @ 30% Net income Economic value added $2,50,000.00 $6,000.00 $2,44,000.00 $73,200.00 $1,70,800.00 $1,58,800.00 Net income is more than the Economic value added this implies that company is not adding value economially as per its potential. The company should earn more income to get more economic value added