Question

The company, in its first year, reported net operating profit after tax of $600,000. The amount...

The company, in its first year, reported net operating profit after tax of $600,000. The amount invested by debt holders was $4,000,000. Equity holders also invested $4,000,000. Interest paid during the year was $240,000 and the weighted average cost of capital is 8%, while the cost of equity capital is 10%. Calculate the company’s economic profit.

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Answer #1

Let us first understand what Economic Profit or Economic Value Added means.

Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as Economic profit, as it attempts to capture the true economic profit of a company.

The formula for calculating EVA is:

{Net Operating Profit After Taxes (NOPAT)} - {Invested Capital * Weighted Average Cost of Capital (WACC)}

The following data is given in the question:

  • NOPAT = 600000
  • Invested Capital = Debt + Equity =4000000 + 4000000 = 8000000
  • WACC = 8%
  • Invested Capital × WACC = 8000000 × 8% = 640000

Therefore, Economic Profit =

= 600000 - 640000

= - 40000 $

Answer: The company in its first year of operation reported a negative economic profit of $ 40000.

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