Question #70 - Reading 23 Residual Income Valuation

Reading: Reading 23 Residual Income Valuation

PDF File: Reading 23 Residual Income Valuation.pdf

Page: 34

Status: Unattempted

Correct Answer: A

Shared Context

- Which of the following assumptions is not commonly used to simplify the calculation of residual income? Continuing residual income is expected to: A) disappear immediately. B) decline to the market average. C) decline gradually as ROE declines.

Question

The economic value added (EV

Answer Choices:

A. −$4.53 million

B. −$8.13 million

C. $2.67 million

Explanation

EVA = NOPAT − (WACC × invested capital). NOPAT = (sales − COGS − SG&A expense − depreciation and amortization expense) × (1 − tax rate) = $17.40 million. To calculate the weighted average cost of capital (WACC), start by determining the percentage of equity and debt. $130 million in debt represented 57.78% of total capital. The remaining 42.22% is the equity portion. Don't forget to adjust the cost of debt for taxes. WACC = 57.78% × (5% × [1 − 40%]) + (42.22% × 11.4%) = 6.55%. EVA = $17.40 million − ($225 million × 6.55%) = $2.67 million. Note that in this problem residual income and EVA are the same. This is true in a "perfect world" but you should not assume this will always be true on exam problems.

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