Financial statements reflect only book values of the data that analysts use to e

Question

Financial statements reflect only book values of the data that analysts use to evaluate a company's performance. To determine if a firm's earnings, after taxes but before the payment of interest and dividends, are sufficient to compensate both the firm's bondholders and shareholders. Stem Stewart Management Services developed an analytical technique called economic value added (EVA). EVA effectively measures the amount of shareholder wealth that the firm's management has added to the value of the firm during a period of time. If EVA is positive, then management has added value, while a negative value indicates that the firm's managers reduced the firm's value and shareholders might have earned more value by investing in some other investment with the same level of risk. Consider this case: Last year, Jackson Tires reported net sales of $80 million and total operating costs (including depreciation) of $52 million. Jackson Tires has $115 million of investor-supplied capital, which has an after-tax cost of 10%. If Jackson Tires's tax rate is 40%, how much value did its management create or lose for the firm during the year? $57.50 million $1.59 million $36.50 million $5.30 million

Explanation / Answer

Net operating profit = $80 million - $52 million = $28 million

Tax rate = 40%

Therefore,

Net operating profit after tax = $28 million x (1 - 0.40) = $16.80 million

The following formula is used to compute EVA:

EVA = Net operating profit after tax - (Capital invested x after-tax cost of capital)

= $16.80 million - ($115 million x 10%)

= $16.80 million - $11.50 million

= $5.30 million

The management created a value of $5.30 million

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