Question

Are these statements correct:

Statement 1: If the present value of future residual income is positive, the stock is underpriced and you should recommend purchasing it.

Statement 2: EVA = NOPAT – (C%×TC), where EVA is economic value added, NOPAT is net operating profit after tax, and (C%×TC) is the cost of capital times total capital.

		Both statements are correct
		Both statements are not correct
		Only Statement 1 is correct
		Only Statement 2 is correct

Answer 1

Both Statements are correct

Residual income measures the differential income which firm generates relative to the required income just necessary to satisfy shareholder's required rate of return. So, if present value of future residual income is positive, stock is underpriced and we should recommend purchasing it.

Economic value added is the incremental difference in the rate of return over a conpany's cost of capital. It is measured as NOPAT-(Invested Capital*Weighted Average Cost of Capital)= NOPAT-(C%*TC)