Question

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16. Use the following data to answer the next question:

Maxim Industries Inc.
Net Operating Income after Tax	$1,000,000
Earnings Before Interest and Tax	$1,200,000
Sources of financing		Cost
Debt	$4,000,000	8%
Equity	$5,000,000	10%	(risk premium)
Total	$9,000,000
Tax rate		40%
Long-term US trasury bond rate		4%	(risk-free rate)
Minimum desired return		8%

a.What is the EVA for Maxim Industries? (Ans: $108,000)

b. What is Maxim’s Industries’ residual income? (Ans: $480,000)

Answer 1

Answer to Part A
		Proportion		Cost of Capital		Proportion*Cost of capital
Debt	4000000	0.444444444	(4000000/9000000)	0.048	0.08*(1-0.40)	0.021333333
Equity	5000000	0.555555556	(5000000/9000000)	0.14	(0.10+0.04)	0.077777778
Total	9000000	Weighted Average cost of capital [(0.0213333+0.07777778)*100]				9.91111%
Net Operating Income after Tax		1000000
Less: Cost of Capital (9000000*9.91111%)		892000
EVA (1,000,000-892,000)		108000

Answer to Part B
Desired Return (9,000,000*8%)	720000
Earnings before Interest and Tax	1200000
Residual Income (1,200,000-720,000)	480000