OBJECTIVE Exercise 10.10 Calculating EVA Brewster Company manufactures elderberr

Question

OBJECTIVE Exercise 10.10 Calculating EVA Brewster Company manufactures elderberry wine. Last year, Brewster earned operating income of $192,000 after income taxes. Capital employed equaled $2.3 million. Brewster is 45 percent equity and 55 percent 10-year bonds paying 6 percent interest. Brewster's marginal tax rate is 40 percent. The company is considered a fairly risky investment and probably commands a 12-point premium above the 4 percent rate on long-term Treasury bonds Jonathan Brewster's aunts, Abby and Martha, have just retired, and Brewster is the new CEO of Brewster Company. He would like to improve EVA for the company. Compute EVA under each of the following independent scenarios that Brewster is considering. (Use a spread- sheet to perform your calculations and round all percentage figures to four significant digits.) Required 1. No changes are made; calculate EVA using the original data. 2. Sugar will be used to replace another natural ingredient (atomic number 33) in the elder- berry wine. This should not affect costs but will begin to affect the market assessment of Brewster Company, bringing the premium above long-term Treasury bills to 10 percent the first year and 7 percent the second year. Calculate revised EVA for both years. 3. Brewster is considering expanding but needs additional capital. The company could borrow money, but it is considering selling more common stock, which would increase equity to 80 percent of total financing. Total capital employed would be $3,000,000. The new after-tax operating income would be $375,000. Using the original data, calculate EVA. Then, recal- culate EVA assuming the materials substitution described in Requirement 2. New after-tax ncome will be $375,000, and in Year 1, the premium will be 10 percent above the long-term Treasury rate. In Year 2, it will be 7-percent above the long-term Treasury rate. (Hint: You 2 will calculate three EVAs for this requirement.)

Explanation / Answer

1. EVA = Net Operation Profts after Tax (NOPAT) - (Capital Employed x WACC)

NOPAT = $192,000 (As given in question)

Capital Employed = $2.3Million

WACC = Weight of Debt x Cost of Debt(net of tax) + Weight of Equity x (Cost of Equity)

Weight of Debt = 55% or 0.55

Weight of equity = 45% or 0.45

Cost of Debt = 6% (1-tax rate) = 6(1-0.40) = 3.6%

Cost of Equity(usinf CAPM) = Risk free return on treasury + Beta (Market return - risk free return)

= 4% + 12% = 16%

NOTE: In the given case beta is not given, therefore we assumed that 12 point premium is Beta market risk premium over the risk free return.

WACC = 0.55 x 3.6% + 0.45 x 16% = 1.98 + 7.2 = 9.18%

EVA = $192,000 - (2,300,000 x 9.18%) = $192,000 - 211,140 = -$19,140

2. EVA for First year with new Changes

Cost of Debt = 3.6%

Cost of Equity = 4% + 10% =14%

WACC = 0.55 x 3.6% + 0.45 x 14% = 8.28%

EVA = $192,000 - ($2,300,000 x 8.28%) = $1,560

EVA for Second year under new changes

Cost of equity = 4% + 7% = 11%

WACC = 0.55 x 3.6% + 0.45 x 11% = 6.93%

EVA = $192,000 - ($2,300,000 x 6.93%) = $32,610

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