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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,

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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 higher than the cost of capital, the company is said to be creating wealth. If net income is lower than the cost of capital, the company is said to be destroying wealth Example: Gainer Company has three sources of financing: 53 million of mortgage bonds paying 5 percent interest, $2.5 million of unsecured bonds paying 8 percent Interest, and $4.5 million of common stock, which is considered to be of average risk (with a 6 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 $768,000. Fill in the following table to calculate the weighted average percent cost of capital. (Round all decimals to four significant digits.) Amount Percent After-Tax Cost Weighted Cost Mortgage bonds $3,000,000 Unsecured bonds 2,500,000 4,500,000 Common stock Total The weighted average percent cost of capital is or Total cost of capital employed is EVAIS Gainer Company is creating wealth. If Gainer Company's tax rate was 30 percent (assume after tax income remains the same), EVA would be lower 11 Gainer Company had $2.5 million of mortgage bonds and $3 million of unsecured bonds, EVA would be lower If Gainer Company had 14.5 million of mortgage bonds and $3 million of common stock, EVA would be higher If Gainer Company was considered more risky than other firms, and the premium on common stock was 8%, EVA would be lower

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