Question

HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had...

HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital (the WACC) was 9.5%, and the federal-plus-state income tax rate was 25%. What was HHH's Economic Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year?

a.

$2,441.25
b.

$2,208.75
c.

$2,563.31
d.

$2,098.31
e.

$2,325.00

Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and the firm's tax rate was 25%. The new CFO wants to see how the ROE would have been affected if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected, and that the interest rate and tax rate would both remain constant. By how much would the ROE change in response to the change in the capital structure?

a.

2.48%
b.

3.06%
c.

3.40%
d.

3.74%
e.

2.76%
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Homework Answers

Answer #1

Answer : 1) Correct option is (e.) 2325.00

Calculation of HHH's Economic Value Added (EVA)

EVA = [EBIT * (1 - Tax rate] - [Investor-supplied operating assets (or capital) * WACC]

EBIT = Sales - Operating Cost

= 12500 - 7025

= 5475

EVA = [5475 * (1 - 0.25)] - [18750* 9.5%]

= 4106.25 - 1781.25

= 2325

Answer : 2) Correct Option is (c.) 3.40%

Calculations :

Proportion of Debt and Equity under Current ROE structure and Proposed ROE structure :

Under Current Structure

Asset = 195000

Debt = 195000 * 27% = 52650

Equity = 195000 - 52650 = 142350

Under Proposed Structure Structure

Asset = 195000

Debt = 195000 * 45% = 87750

Equity = 195000 - 87750 = 107250

Current ROE Proposed ROE
Sales 303225 303225
Less : Operating Cost 267500 267500
Earning Before Interst and Taxes 35725 35725
Less : Interest 4317.3(52650 * 8.2%) 7195.5(87750 * 8.2%)
Earning Before Taxes 31407.7 28529.5
Less : Taxes@25% 7851.925 7132.375
Earning for Equity shareholder 23555.775 21397.125
Divided by Equity 142350 107250
ROE 16.55% 19.95%

Change in ROE = 19.95% - 16.55%

= 3.40%

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