- 20 Marks
Question
Peter Drucker opined that “until a business returns a profit that is greater than its cost of capital, it operates at a loss.” Therefore, experts have challenged accounting profit as a good measure of business value increase and proposed economic value added (EVA) as a better measure.
Tees Nigeria Limited has presented the following financial data for the year ended 31 December 2018:
Income Statement 2018:
| Item | ₦000 |
|---|---|
| Profit before interest and tax | 75,000 |
| Interest cost | (9,000) |
| Profit before tax | 66,000 |
| Tax at 30% | (19,800) |
| Profit after tax | 46,200 |
| Dividends paid | (30,000) |
| Retained profit | 16,200 |
Statement of Financial Position 2018:
| Item | ₦000 |
|---|---|
| Non-current assets | 305,000 |
| Net current assets | 190,000 |
| Total assets | 495,000 |
| Shareholders’ funds | 395,000 |
| Long-term debt | 100,000 |
| Capital employed | 495,000 |
Notes:
(i) Capital employed at the beginning of the year was ₦420 million.
(ii) The company had non-capitalised leased assets of ₦24 million.
(iii) The estimated cost of equity was 10%, and the cost of debt was 7%.
(iv) The company’s target capital structure is 60% equity and 40% debt.
(v) Other non-cash expenses were ₦16 million.
(vi) Depreciation is equal to economic depreciation.
Required:
a. Discuss the perceived benefits of using EVA to measure business performance. (10 Marks)
b. Calculate the real economic profit of Tees Nigeria Limited using EVA. (10 Marks)
Answer
(a) Perceived Benefits of Using EVA:
- Alignment of Interests: EVA closely aligns the interests of shareholders and management by focusing on wealth creation.
- Focus on Value Creation: It emphasizes value creation over accounting profit, ensuring that companies pursue strategies that increase shareholder wealth.
- Long-term Perspective: EVA encourages long-term decision-making, as it includes the cost of capital, ensuring that all capital employed earns at least the cost of funding.
- Profitability Measure: Unlike accounting profit, EVA includes the cost of both equity and debt, making it a more comprehensive measure of profitability.
- Reward Scheme: EVA can be used as a basis for management compensation, rewarding managers for true value creation.
- Investment Appraisal: It helps in evaluating investment projects by focusing on their contribution to overall value.
- Improved Decision Making: It enhances managerial focus on capital efficiency and overall business health.
- Accountability: EVA holds management accountable for both operational performance and the use of capital.
- Ease of Understanding: Though sophisticated, it can be simplified and made understandable for stakeholders.
- Objective Performance Indicator: It provides an objective measure of business performance compared to traditional accounting measures.
(b) Calculation of Economic Profit Using EVA:
| Item | ₦000 |
|---|---|
| Profit after tax | 46,200 |
| Add: Interest cost less tax (₦9,000 × 70%) | 6,300 |
| Add: Non-cash expenses | 16,000 |
| NOPAT (Net Operating Profit After Tax) | 68,500 |
Capital Employed:
| Item | ₦000 |
|---|---|
| Capital employed at year start | 420,000 |
| Add: Non-capitalised leased assets | 24,000 |
| Total Capital Employed | 444,000 |
WACC Calculation:
WACC= (10%×60%) + [7%× (1−30%) ×40%] = 7.96%
EVA Calculation:
| Item | ₦000 |
|---|---|
| NOPAT | 68,500 |
| Less: Capital charge (₦444,000 × 7.96%) | (35,342.4) |
| EVA (Economic Value Added) | 33,157.6 |
- Tags: Business performance, Capital Employed, EVA computation, NOPAT, Profit measurement, WACC
- Level: Level 2
- Topic: Divisional Performance Measurement
- Series: MAY 2019
- Uploader: Kwame Aikins