The following information is from the financial statements of Duke Company for t

ID: 2423691 • Letter: T

Question

The following information is from the financial statements of Duke Company for the fiscal year just ended:

Total assets $6,000,000

Current liabilities 1,250,000

Operating income 1,140,000

a. Calculate return on investment (ROI).

b. Calculate residual income (RI), assuming the required rate of return is 18%.

c. Calculate economic value added (EVA) assuming (1) Duke has two sources of funds—long-term debt with a market value of $2,500,000 and an interest rate of 10%, and equity capital with a market value of $5,000,000 and a cost of equity of 16%—and (2) Duke’s income tax rate is 30%.

Explanation / Answer

ROI=Income/Invested Capital

1,140,000/4,750,000=.24 or 24%

Invested capital = Total assets – current liabilities

$6,000,000-1,250,000

$4,750,000

Residual income=profit-(Invested Capital *required rate of return)

=$1,140,000-(4,750,000*18%)

=$285,000

Economic value added (EVA)

Weighted Average Cost of capital is used in the calculation of Economic value added which is the most contemporary measure of investment centre performance.

Weighted Average Cost of capital (WACC) is calculated as under:

Interest rate on debt is 10%

So after tax cost of debt is (10% (1-30%) which is equal to 7%

Long term debt is $2,500,000

Cost of equity capital is 16% and market value of equity is $5,000,000

Therefore, WACC is 13 percent

Economic value added is calculated using the below mentioned formula as under:

Division

Real estate

Before Tax operating Income

$1,140,000

Tax rate

30%

After Tax Operating Income (a)

$798,000

Total assets (b)

$6,000,000

Current Liabilities (c)

$1,250,000

WACC (d)

0.13

Economic value added (a-[(b-c)*d]

$180,500