Mother – Please Speak out

ABC ltd , a three-year-old company that specializes in direct-to-consumer sales of

high-tech gadgets. Exhibit 1 shows abbreviated financial statements for 2017-
2018. The CEO is particularly proud of this year’s results: sales are up 33% from
$75.0M in 2018-19, and net income is up 50% from $2.8M in 2018-19. However, to
assess whether ABC ltd is adding or destroying economic value, he decided to
calculate EVA as well.
Exhibit 1
The financial statements ABC LTD is given below.
Income Statement for the year ended March 31, 2019 ($000s)
Net Sales 100,000
Cost of sales 50,000
R&D 15,000
Sales and Marketing 10,000
Other Expenses 10,000
Depreciation 5,000
Operating Earnings 10,000
Interest paid 3,600
Pre-tax profit 6,400
Taxes (34%) 2,176
Net Income 4,224

Balance Sheet as of March 31, 2019

Assets
Cash and cash equivalents 10,000
Accounts Receivable 20,000
Inventories 10,000
Property, plant and equipment-gross 50,000
Other fixed assets 5,000
Total Assets 95,000
Liabilities and Shareholders' Equity
Accounts payable 15,000
Debt 40,000
Total Liabilities 55,000
Shareholders' Equity 40,000
Total Liabilities and Shareholders' Equity 95,000

Question a: Calculate the WACC of the company

Given
1. tax rate of 34%
2. Company’s beta is 1.2,
3. the risk-free rate is 5%, and
4. the appropriate Market Risk Premium is 7.2%,
 5. The company pays a 9% annual interest on its debt.
6. Given a capital structure of 50% debt and 50% equity,

Question b. Calculate Economic Value Added to the company. The inputs required
to compute EVA can be obtained from the firm’s financial statements.
In spite of the significant growth in revenues and in net income, is its management
team really destroying wealth?

Question c.
Accounting rules are often a compromise between potentially conflicting
objectives, such as providing economically relevant and timely information while
maintaining certain standards in terms of reliability and verifiability.

As a result, the numbers reported in the financial statements may not be

consistent with the EVA objective to measure economic performance.

Under the existing accounting rules, not all economic assets and liabilities are
recognized on the balance sheet. Under IFRS, for example, certain types of
leases (so-called operating leases) only affect the income statement because
under the terms of the contract the leased assets cannot be viewed as being
“owned” by the firm.

Moreover, certain long-term investments do not fit the accounting definition of

assets and are therefore reported as expenses. For example, IFRS generally
requires research and development (R&D) expenditures to be expensed in the
year incurred, rather than being capitalized and amortized over the expected
useful life. While standard setters recognize the potential long-term benefits of
investments in R&D, concerns regarding the reliability of such benefits have
prevailed. From a performance evaluation and incentive perspective, however, such
accounting treatment may lead to significant underinvestment in R&D as the cost
of the investment is fully recognized in the current period while the benefits will
show up only in later years.

After reviewing the direct calculation of EVA, CEO and CFO of ABC ltd decided to
implement two key adjustments to present accounting before arriving their EVA
measurement.
R&D adjustment As a high-tech company, ABC ltd relied extensively on R&D
investments to provide the most innovative products on the market. Since the
product development cycle was about three years, the management team decided
to capitalize R&D and amortize it in a straight-line fashion over a three-year
period. R&D expenditures were $6.0M in 2016-17, $9.0M in 2017-18, and $15.0M
in 2018-19.

Operating lease adjustment ABC ltd was growing so fast that it could no longer
store its inventory at the factory. In fact, at the beginning of 2018-19, the
company entered into a 10-year lease for a warehouse and fulfillment center near
the factory. Lease expenses were $2M a year (included in other Expenses) and
the imputed lease rate identical to the company’s 9% debt rate. Under IFRS, this
new operating lease did not appear on the financial statements, but the
management team decided to capitalize the lease for the purpose of calculating
EVA.

Reconstruct the financial statement after providing the adjustment for R&D
and Operating Lease and Calculate Economic Value Added to the company

Question d.
Assume a project that requires an initial investment of $100. The project is
depreciated over four years using the straight-line-method and generates after-
tax operating cash flows of $50 per year for four years.
No additional investments in fixed assets or working capital are required after the
initial investment. The cost of capital is 10%.
Calculate
A) The Net Present Value of Free Cash Flows and
B) The Present Value of EVAs associated with this project.