Economic Value Added (EVA)

Economic Value Added (EVA) is similar to residual income in that income is compared to the cost of investment used to earn that income. However, there are some key differences. EVA uses: net (after-tax) income, and the true cost of capital (or investment) rather than some predetermined hurdle rate. If net income is - Select your answer -lowerhigherItem 1 than the cost of capital, the company is said to be creating wealth. If net income is - Select your answer -lowerhigherItem 2 than the cost of capital, the company is said to be destroying wealth.

Example: Gainer Company has three sources of financing: $2,920,000 of mortgage bonds paying 4 percent interest, $2,390,000 of unsecured bonds paying 8 percent interest, and $4,690,000 of common stock, which is considered to be of average risk (with a 7 percent premium). The company's tax rate is 40 percent and the rate of interest on long-term government bonds is 3 percent. Last year, Gainer Company had after-tax income of $809,300. Fill in the following table to calculate the weighted average percent cost of capital. (Enter your percent answers in decimal form and round all answers to four decimal places, if required. Use the rounded answers in subsequent requirements.)

	Amount	Percent	After-Tax Cost	Weighted Cost
Mortgage bonds	$2,920,000
Unsecured bonds	2,390,000
Common stock	4,690,000
Total	$

(Round decimal answer to four decimal places and percent answer to two decimal places, e.g. 0.0234 or 2.34%.)

The weighted average percent cost of capital is or %

Total cost of capital employed is $

EVA is $

Gainer Company is - Select your answer -creatingdestroyingItem 18 wealth. If Gainer Company's tax rate was 30 percent (assume after-tax income remains the same), EVA would be - Select your answer -higherlowerthe sameItem 19 . If Gainer Company had $2,420,000 of mortgage bonds and $2,890,000 of unsecured bonds, EVA would be - Select your answer -higherlowerthe sameItem 20 . If Gainer Company had $4,420,000 of mortgage bonds and $3,190,000 of common stock, EVA would be - Select your answer -higherlowerthe sameItem 21 . If Gainer Company was considered more risky than other firms, and the premium on common stock was 8%, EVA would be - Select your answer -higherlowerthe sameItem 22 .