I have a question about an economic value added question from the Ninja MCQ. The question is below.
Zig Corp. provides the following information:
Pretax operating profit $300,000,000
Tax rate 40%
Capital used to generate profits 50% debt, 50% equity $1,200,000,000
Cost of equity 15%
Cost of debt 5%
What of the following represents Zig's year-end economic value added amount?
A.$0
B.$60,000,000
C.$120,000,000
D.$180,000,000
The answer was D but I chose B because I though the calculation was:
$1,200,000,000 (investment) x 10% (cost of capital) = Required return
Then $180,000,000 (income after taxes) – $120,000,000 (Required return) = $60,000,000
This was the answer reasoning.
The economic value added amount (EVA) is calculated by multiplying the capital employed at the beginning of the period by the difference between the return on capital employed (RCOE) and the weighted average cost of capital (WACC). Since a company is worth its book value if the RCOE is equal to its WACC, the positive difference between the two would be the percentage by which the value of the business is increased.
The return on capital employed (RCOE) is a way of measuring the efficiency with which a company is using its capital to generate revenue. RCOE is the pretax operating profit divided by the capital employed. For Zig Corp, this would be 0.25, or 25% ($300,000,000 ÷ $1,200,000,000).
The weighted average cost of capital is the weighted average of the cost of debt and the various equity components of the firm's capital structure. For Zig Corp, this weighted average is the sum of the two costs provided in the question, or 20% (15% + 5%).
RCOE = 300/1200 = 0.25, or 25%
WACC = (Kdebt x Wt.debt) + (Kequity x Wt.equity)
= (0.50 x 0.05) + (0.50 x 0.15)
= .025 + .075 = .100
EVA % = 0.25 – 0.10 = 0.15
EVA = 0.15 x $1.2 billion = $180 million
The tax rate is not pertinent information in this problem.
REG - 78
BEC - 74, 67, 69, 69, 70, 79
FAR - 76
AUD - 69, 69, 69, 74, 85
Licensed Louisiana CPA
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