5、Elpo Corporation Case Scenario

Stacy Alba and Helen Yang are analysts in the trust department of a large U.S. bank. They are valuing the common stock of Elpo Corporation. Their valuation process thus far has focused on applying dividend discount and free cash flow models. They have now decided to add the results given by residual income models—including economic value added (EVA)—and cash flow return on investment (CFROI) to their recommendation to the bank’s Investment Committee.

Alba and Yang have spent much time discussing the additional models; considering their advantages, disadvantages, and requirements; and comparing them to the other models they had already used to value Elpo. Early in their discussions, Alba made this statement:

"EVA and return on equity (ROE) are similar in that both measure a firm’s profitability with reference to the amount and cost of capital.”

Alba later made the following observation:

"Initially two factors caused concern in selecting a valuation model for Elpo:

1.      Elpo pursues a policy of not paying dividends on its common shares. 

2.      Some changes in Elpo’s book value have been recorded directly to shareholders’ equity instead of flowing through the firm’s income statement.

"I have concluded that the residual income model readily applies to both circumstances. Therefore, we will not need to make the complicated adjustments that might be required with other valuation models.”

Yang asked a question:

"After we calculate EVA and CFROI for Elpo, I know we can also calculate the EVA spread and the CFROI spread. But how should we interpret those two measures?”

Alba and Yang are now valuing the common stock of Elpo, using EVA, CFROI, and other residual income models. Financial information relating to Elpo is given in Exhibit 1.

Exhibit 1

Financial Information

Elpo Corporation

Question 1

With respect to Alba's statement about economic value added (EVA) and return on equity (ROE), she is correct in the case of:

A. EVA, but not ROE.

B. ROE, but not EVA.

C. both EVA and ROE.

D. neither EVA nor ROE.

Question 2

With respect to Alba's observation, is her conclusion about applying the residual income model correct in the case of:

A. Answer A

B. Answer B

C. Answer C

D. Answer D

Question 3

With respect to Yang's question, both of the spread measures identified are most accurately interpreted as focusing on the difference between a firm's return on invested capital and that firm's:

A. cost of equity.

B. marginal cost of debt.

C. expected long-term ROE.

D. weighted average cost of capital.

Question 4

Elpo's net operating profit after tax (NOPAT) in thousands for 2006 was closest to:

A. $2,426.

B. $2,757.

C. $2,909.

D. $3,240.

Question 5

Elpo's dollar cost of capital ($WACC) in thousands for 2006 was closest to:

A. $1,904.

B. $2,236.

C. $2,407.

D. $2,449.

Question 6

Elpo's residual income in thousands for 2006 was closest to:

A. $235.

B. $522.

C. $1,987.

D. $2,274.

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