Question

An entrepreneur has come up with an idea for a product that he will be able to produce and sell over four years. At time t = 0 (first year 1) he creates a company by depositing DKK 3.000.000 in cash (Equity). The company immediately acquires a production plant for the 3.000,000 (acquisition value). The life of the production plant is precisely 4 years. Over the 4 years the company generates the following net cash flows (revenue from sale of goods minus the costs of producing the goods):

CF0= -3.000.000 CF1 = 420.000, CF2 = 882.000, CF3 = 1.157.625, and CF4 = 972.405

For convenience, assume that all cash flows fall on the last day of the year and that the entire net cash flow received is immediately paid to the entrepreneur as a dividend. Therefore, there is no cash and cash equivalents at the end of each year in the company. The interest rate is assumed to be 5%. VAT and taxes should not be taken into account.

Calculate the economic value at the end of each year and the financial profit for each of the 3 years.

Answer 1

First of all,

The formula for ECONOMIC VALUE ADDED (EVA) is:

                              EVA = Net operating profits after tax – (Invested Capital * WACC)

Total capital structure comprises only EQUITY of value DKK 3,000,000.

Therefore, the weighted cost of capital (WACC) is the same as the COST OF EQUITY (K_e) and that is the same as the INTEREST RATE, i.e., 5%. (no other values needed to calculate the cost of equity are not provided in the question.)

Moreover,

The operating or the financial profits of each have to be calculated using the cash flows provided.

Cash flows here are the difference of REVENUE & COST OF PRODUCTS which means, the cash flows are similar to the GROSS MARGIN/PROFIT in this question.

An extra operating expense namely, DEPRECIATION ON PLANT is also there.

                              DEPRECIATION = (ACQUISITION COST – SALVAGE VALUE) / ESTIMATED LIFE

                              DEPRECIATION = (3,000,000 - 0) / 4

                              DEPRECIATION = 750,000

Hence, the FINANCIAL PROFIT/LOSS for each year is as follows:

PARTICULARS	YEAR 1	YEAR 2	YEAR 3	YEAR 4
CASH FLOWS/GROSS PROFIT	420,000	882,000	1,157,625	972,405
DEPRECIATION	(750,000)	(750,000)	(750,000)	(750,000)
NET OPERATING PROFIT/(LOSS)	(330,000)	132,000	407,625	222,405

(*the financial profits = operating profits, as taxes are to be ignored as per the question.)

Hence, THE ECONOMIN VALUE ADDED (EVA) at the end of each year is:

PARTICULARS	YEAR 1	YEAR 2	YEAR 3	YEAR 4
Invested Capital (IC)	3,000,000	3,000,000	3,000,000	3,000,000
WACC	5%	5%	5%	5%
IC * WACC	150,000	150,000	150,000	150,000
NET OPERATING PROFIT/(LOSS)	(330,000)	132,000	407,625	222,405
Hence,
ECONOMIC VALUE (b - a)	(480,000)	(18,000)	257,625	72,405