6 ndo U (A take Calculating EVA Brewster Company elderberry wine. Last year, Bre

Question

6 ndo U (A take Calculating EVA Brewster Company elderberry wine. Last year, Brewster earned operating income of $186,000 after income taxes. Capital employed equaled $2.1 million. Brewster is 45 percent Oequilty and 55 percent 10-year bonds paying 6 percent interest. Brewsters marginal tax rate is 40 percent. The company is considered a fairly risky investment and probably commands a 13 point premium above the 4 percent rate on long-term Treasury bonds. onathan 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. Required: Company, bringing the premium above long-term Treasury bilts to 11 percent tie first and s percent the EVA . Brewster is considering of total f the materials s 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 o. Total capital employed would be $3,000,000. The new after-tax operating income would be $390,000. Using the original data, calculate EVA. Then, recalculate EVA assuming described in Requirement 2. New after-tax income will be s: 10,000, and in Year 1, the premium will be 11 percent above the long-term Treasury rate. In Year 2, it will be percent above the long-term Treasury rate. (hint: You wcalculate three EVAs for this requirement.) EVA here to

Explanation / Answer

1. EVA with no changes

EVA = Net Operating income after tax – (Capital employed x Weighted average cost of capital)

Net operating profits after tax = $186,000

Capital Employed = $2.1 million

Calculation of Weighted Average cost of capital(WACC)

WACC = (Weight of equity in company x Cost of equity) + (Weight of debt in company x Cost of Debt)

Weight of Equity = 0.45 or 45%

Weight of Debt = 0.55 or 55%

Cost of Debt (Net of Tax) = 6%(1- .40) = 3.6%

Cost of Equity (CAPM method) = Risk free rate of interest + Beta (market risk return – risk free return)

                                                     = 4% + 13% = 17%

NOTE: In the given question, it is not possible to calculate the Beta and therefore we have assumed that 13 points premium given is inclusive of Beta factor in rate of return.

NOTE: Risk free rate of return is return on long term treasury bonds as these are considered risk free in the market.

WACC = (0.45 x 17%) + (0.55 x 3.6%) = 9.63%

Putting the above figures in EVA formula

EVA = $186,000 – ($2,100,000 x 9.63%) = -$16,230

2. a. EVA when point premium is 11%

EVA = Net Operating income after tax – (Capital employed x Weighted average cost of capital)

Net operating profits after tax = $186,000

Capital Employed = $2.1 million

Calculation of Weighted Average cost of capital(WACC)

WACC = (Weight of equity in company x Cost of equity) + (Weight of debt in company x Cost of Debt)

Weight of Equity = 0.45 or 45%

Weight of Debt = 0.55 or 55%

Cost of Debt (Net of Tax) = 6%(1- .40) = 3.6%

Cost of Equity (CAPM method) = Risk free rate of interest + Beta (market risk return – risk free return)

                                                     = 4% + 11% = 15%

WACC = (0.45 x 15%) + (0.55 x 3.6%) = 8.73%

EVA = $186,000 – ($2,100,000 x 8.73%) = $2,670.

2. b. EVA when point premium is 8%

Cost of Equity = 4% + 8% = 12%

WACC = (0.45 x 12%) + (0.55 x 3.6%) = 7.38%

EVA = $186,000 – ($2,100,000 x 7.38%) = $31,020

3. a. EVA with new capital structure

Cost of equity = 17%

WACC = (0.80 x 17%) + (0.20 x 3.6%) = 14.32%

Capital Employed = $3,000,000

Net operating income after tax = $390,000

EVA = $390,000 – ($3,000,000 x 14.32%) = -$39,600

b. EVA with 11% premium

Cost of equity = 4% + 11% = 15%

WACC = (0.80 x 15%) + (0.20 x 3.6%) = 12.72%

EVA = $390,000 - ($3,000,000 x 12.72%) = $8,400

c. EVA with 8% premium

Cost of equity = 4% + 8% = 12%

WACC = (0.80 x 8%) + (0.20 x 3.6%) = 7.12%

EVA = $390,000 - ($3,000,000 x 7.12%) = $176,400

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