Question #3

of 76 Economic value added (EVA®) is calculated as net operating profit after taxes minus: A) a charge for total capital. B) capital expenditures. C) a charge for equity capital. You are the chairperson of the board of Retty Inc. You are reviewing the statistics on management performance over the past three years. The accounts of the firm are summarized below: Exhibit 1: Income Statement 20x4 $m 20x5 $m 20x6 $m Sales 40.2 42.3 43.9 Cost of goods sold (11.6) (12.3) (12.8) (11.6) (12.3) (12.8) Gross profit 28.6 30.0 31.1 Administrative expenses (10.0) (10.0) (3.0) Earnings before interest and tax 18.6 20.0 28.1 Interest (6.3) (6.3) (4.2) Earnings before tax 12.3 13.7 23.9 Tax (5.1) (5.6) (11.4) Net income 7.2 8.1 12.5 Dividends (3.0) (3.1) (3.2) Retained income 4.2 5.0 9.3 Exhibit 2: Balance Sheet at 31 December 20x3 $m 20x4 $m 20x5 $m 20x6 $m Total assets 100.0 104.2 109.2 110.5 Liabilities 24.0 24.0 24.0 16.0 Common stock 20.0 20.0 20.0 20.0 Additional paid up capital 10.0 10.0 10.0 10.0 Retained income 46.0 50.2 55.2 64.5 100.0 104.2 109.2 110.5 Market value of equity (31 December) 167 203 199 145 Beta of firm = 1 Debt holders' required rate of return: 5% Equity holders' required rate of return: 15% After tax WACC: 12.5% Tax rate: 45% Notes: 1. Administrative expenses include goodwill write downs of $7m in 20x4 and 20x5— goodwill is fully written off by the end of 20x5 2. $8m of debt was redeemed at the start of 20x6 3. Other than the debt redeemed in 20x6, the liabilities consist mostly of long-term debt valued approximately at book value 4. Replacement value of assets is roughly equal to book value minus 4%