Question 7 - 38715

The Erica Company has the following financial information:

Part 1)
Which of the following ratios posted the biggest percentage change from year end 2003 to year end 2004?

Part 2)
If gross profits rise, operating profits are flat, and capital spending declines in 2005, which of the following ratios is most likely to rise?

Part 3)
2004 NOPAT is closest to:

Part 4)
Erica Company’s 2004 weighted average cost of capital is closest to:

Part 5)

• EBIT  = $615 million.

• Net debt = $600 million.

• Equity = $750 million.

• Marginal tax rate = 35%.

• Operating profit margin = 15%.

• Weighted average cost of capital = 10%.

• Required rate of return on equity = 12%.

Assuming the above facts, EVA is closest to:

Part 6)
Which of the following statements about the EVA calculated in the previous question is FALSE?

Question

Part 1)
Your answer: B was correct!

The debt/capital ratio changed from 26.4% (4,962/(13,852+4,962)) to 19.6% (4,821/(19,715+4,821)), down 26%.
ROE changed from 3.0% (417/13,852) to 2.5% (490/19,715), down 17%.
ROA changed from 1.7% (417/24201) to 1.6% (490/30,362), down 6%.
Financial leverage changed from 1.747 (24,201/13,852) to 1.540 (30,362/19,715), down 12%.

Part 2)
Your answer: B was correct!

If gross profits rise and operating profits are flat, the likely reasons are either higher sales or lower COGS with the most likely being an increase in sales greater than an increase in COGS. Higher sales would most likely lead to an increase in inventory turnover due to a related increase in COGS or lower average inventory on hand. Flat profits and minimal investment in new assets are likely to limit the growth of ROE and ROA. Without increases in the asset base or decreases in equity, financial leverage is not likely to rise.

Part 3)
Your answer: B was incorrect. The correct answer was A) 455.

NOPAT = (sales - COGS - SGA - dep) x (1 - t)
= (9,889 - 4,691 - 3,960 - 479) x (1 - 0.40)
= 455

Part 4)
Your answer: B was incorrect. The correct answer was A) 11.34%.

Capital = debt + equity = 4,821 + 19,715 = 24,536
Equity weight = 19.715 / 24,536 = 80.4%
Debt weight = 1 – equity weight = 19.6%
k_equity = r_f + (r_m – r_f) β = 0.03 + 0.08 x 1.26 = 13.08%
The pretax required return on debt is 7%
Tax rate = 40%

WACC = (80.4% * 13.08%) + (19.6% * 7% * [1 - 40%])
= 10.51% + 0.83% = 11.34%

Part 5)
Your answer: B was correct!

NOPAT (Net operating profit after taxes) = $615 million x 0.65  = $400 million
EVA = NOPAT – (WACC * capital)
= $400 million – (10% * [$750 million + $600 million]) = $265 million

A key to success here is determining the proper figure for capital. Net debt of $600 million combined with $750 million in equity represents total capital of $1,350 million.

Part 6)
Your answer: B was correct!

A positive EVA does mean the firm was successful at creating economic profits and did add value by investing in positive NPV projects thereby developing a sustainable competitive advantage.