Suppose that your boss just turned to you for insights on the concept of Economic Value Added

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Question:

Suppose that your boss just turned to you for insights on the concept of Economic Value Added (EVA) for performance evaluation purposes. His newly acquired interest in EVA developed after he received a notice last month from corporate headquarters indicating that the company will soon be adopting the concept of EVA as a supplemental decision-making tool – primarily to evaluate the year-to-year performance of the firm’s respective divisions. Because your boss is not familiar with the concept (one of the many dinosaurs that remain in the business world), he is quite concerned about its application and how it relates to traditional capital budgeting theory that suggests investing in all + NPV projects. “I just don’t get it”, he proclaims, “We all know that the appropriate goal for a financial manager has been, and always will be, to invest in projects that add value for shareholders. Joe, from corporate HQ said that some punk bald professor from the Kelley School of Business is responsible for convincing the higher-ups to move in this direction. …..If I could just get my hands on that guy, I would tear him in half. I am scheduled to retire in 3 years, and I don’t need this kind of pressure at my age!” Recognizing that your boss is clearly concerned – primarily because he does not understand the direct relation between NPV and EVA, you offer your assistance (note: this is the first time you learned that your boss was planning to retire in 3 years – what a great opportunity for you to show how much you really know!). Reluctantly, you state, “Um, boss, NPV and EVA are entirely consistent.” As his beady eyes roll your way, you feel a drop of sweat form on your temple. “What do you mean by entirely consistent insert your name here?” 3 (Maybe you have just screwed up? You had a comfortable position with a good salary and now your neck is possibly on the chopping block!) With your nervousness clearly showing through, you reply “Boss, in theory, the present value of all future EVA is the same as NPV.” Without wasting any more time, your boss counters “Here are some hypothetical figures for a project. Calculate the period-by-period EVA for this project and then tabulate the PV of all future EVA.” He then adds, “I already know the project’s NPV because I have calculated it myself! We’ll compare the present value of your EVA figures with my NPV figure when you complete your EVA calculations.”

Cash Flow Information T = 0 T = 1 T = 2 T = 3 T = 4 to infinity Sales $90k $120k $180k $125k Costs $37k $40k $60k $40k Depreciation $30k $30k $40k $25k Capital Investment $210k $40k $40k $30k $25k NWC Investment $20k $10k $10k $10k $0k Additional information: Debt / Equity = 0.8 (target); Rf = 5%;  = 1.1; market risk premium = 7.5%. The firm’s bonds have a $1,000 face value, pay semiannual coupons (coupon rate = 6.5%), mature in 7 years, and are currently selling in the open market for $920.78. The appropriate tax rate is 30%.