Mother $-$ Please Speak out

ABC Itd, a three$-$year$-$old company that specializes in direct$-$to$-$consumer sales of high$-$tech gadgets. Exhibit

$1$ shows abbreviated financial statements for $2022-2023.$ The CEO is particularly proud of this year's results:

sales are up $33\%$ from $$75\mathrm{.}0$M in $2021-22,$ and net income is up $50\%$ from $$2\mathrm{.}8$M in $2021-22.$ However, to assess

whether ABC Itd is adding or destroying economic value, he decided to calculate EVA as well.

Exhibit $1$

The financial statements ABCLTD is given below.

Question a: Calculate the WACC of the company

Given

tax rate of $34\%$

Company's beta is $1\mathrm{.}2,$

the risk$-$free rate is $5\%,$ and

the appropriate Market Risk Premium is $7\mathrm{.}2\%,$

The company pays a $9\%$ annual interest on its debt.

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?

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 Itd decided to implement two key

adjustments to present accounting before arriving their EVA measurement.

R&D adjustment As a high$-$tech company, ABC Itd 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 $$6\mathrm{.}0$M in $2016-17,$ $$9\mathrm{.}0$M in $2017-18,$ and $$15\mathrm{.}0$M in $2018-19.$

Operating lease adjustment ABC Itd 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 $$2$M 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.