Question

9. Value added to a firm 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 7.5%. 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)? 0 $10,537,500 0 $43,837,500 O $3,424,688 0 $41,737,500

Answer 1

EVA = Net Operating profit After tax – Invested Capital*Cost of capital

= (80,000,000-52,000,000)(1-40%) – 83,500,000*7.5%

= $10,537,500

Hence, value added during the year = $10,537,500

Value of Stock = Next Expected Dividend/(Required Rate of Return – Growth Rate)

= 2.75(1+3%)/(11%-3%)

= $35.40625

i.e. $35.41

Value = 2.75(1+3%)/(14%-3%)

= $25.75

Fall in value by $9.66