[Mhayes22]

NINJA Question –

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

Incorrect D.

$180,000,000

Answer provided:

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.

EVA is the income earned in excess of the normal rate of return represented by the WACC. Since the debt and equity proportions are each 50%, the WACC is 10% ((15% + 5%) ÷ 2).

Capital $1,200,000,000

WACC x 0.10

Normal return $ 120,000,000

Net income after tax ($300,000,000 x 0.60) 180,000,000

EVA ($180,000,000 – $120,000,000) $ 60,000,000

According to every WACC computation I have performed you consider the after-tax benefit of the cost of debt. Therefore the WACC should be computed as follows.

Equity = 15% x .50 = 7.5%

Debt = 5% x. 50 x = 2.5% (pre-tax), After-tax benefit = 2.5% x (1-.4) = 1.5%

WACC = 9%

180m – (1,200m x .09) = 72m

Any one understand why the after-tax of debt was not considered in the computation of the WACC?

AUD: 99
FAR: 90
REG: 96
BEC: 90
Done!

[spatel15]

I haven't started much BEC yet, but you're right. Only thing is, did your previous questions mention pre-tax? This may be one of those cases where you assume after-tax, unless stated otherwise, but again I can't say it for sure since this is the first problem I've seen lol. But in terms of calculation, EVA does take into account the tax benefit of the cost of debt.

Unless this is in a perfect market and capital structure doesn't mean shiiit. <–But something they'd definitely need to state, because that'd be a heinous assumption for accountants to make…given the whole tax profession thing.

[spatel15]

Good luck on the 97

[jeff]

Implicit is that the cost of debt has the tax factored in.

Don't shoot the messengers – the ninjas didn't write the question. 🙂

The takeaway is that if your answer isn't coming out on exam day ~ make sure you're not reading something into the question that isn't there. The fact that one item is noted as being pre-tax…assume the others are not, unless indicated.

Jeff Elliott, CPA (KS) | Another71 | NINJA CPA | NINJA CMA | NINJA CPE

[Mhayes22]

I appreciate the responses. Looks like I assumed the Cost of debt was pre-tax. However, the cost of debt was already in after-tax form.

AUD: 99
FAR: 90
REG: 96
BEC: 90
Done!

[jeff]

I've had several questions about this one.

Jeff Elliott, CPA (KS) | Another71 | NINJA CPA | NINJA CMA | NINJA CPE

[Author]

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