Solution To Case 22: EVA - Does It Really Work?

Solution to Case 22
Economic Value Added (EVA)
EVA Does It Really Work?

Questions:
1. Calculate and interpret Gannon Manufacturing Companys key liquidity,
profitability, turnover, and leverage ratios. What do the ratios indicate?
Ratios
2004
2003
1.99
0.93
2.61%
1.92
0.95
3.04%
0.68
2.17
3.17
8.84
0.70
2.34
3.34
6.58
Liquidity Ratios
Current Ratio
Quick Ratio
Cash Ratio
Long-term solvency ratios
Total Debt Ratio
Debt-Equity Ratio
Equity Multiplier
Times Interest Ratio
Asset utilization ratios
Inventory Turnover ratio
2.51
3.08
Day's sales in Inventory
145.47 days 118.60 days
Receivables Turnover
5.12
5.58
ACP or Days' Sales in Receivables 71.29 days 65.35 days
Total Asset Turnover
1.80
2.04
Profitability ratios
Profit Margin
ROA
ROE
3.68%
6.63%
20.99%
2.14%
4.38%
12.62%
Liquidity:
The firms current ratio is almost 2.0, and has increased from the previous year.
This is good. However, the quick ratio and cash ratio have dropped a bit. The
overall liquidity position seems to be satisfactory, but further information would be
needed about the marketability and condition of inventory.
Profitability:
The firms profitability ratios have increased quite significantly in 2004. The ROE
increased by almost 44% over the 2003 level (from 14.62% to 20.99%) in spite of
the fact that the debt ratio was lower. This is a healthy sign.
Asset utilization
Inventory turnover and accounts receivable turnover have deteriorated in 2004. The
firm may need to look into managing its inventory and credit better.
Long-term solvency
Overall, the company has reduced the proportion of debt in its capital structure.
The debt ratio is still relatively high at 68% of total assets, but the interest coverage
ratio is pretty high as well (8.84X).
Overall, the ratios indicate that the companys liquidity is satisfactory. Its leverage
is on the higher side but since its interest coverage is good it may not be considered
risky. The strongest side of the firm is its profitability and its weakest aspect is its
asset turnover ratios. Comparison with the industry benchmark would help shed
some light on this issue. However, it seems that some improvement in inventory
and credit management may be warranted.
2. Calculate the firms NOPAT for both years. $40,000 of the owners salary
was considered to be a reinvestment for future growth of the firm.
(In thousands of $)
NOPAT =
Net Income
+Total Adjustments
-Opportunity Loss of Tax savings on Adjustments
NOPAT
2004
2003
166
50
-20
196
101
45
-18
128
3. What are the relative proportions of debt and equity in Gannon

Manufacturing Companys capital structure?
Weight
9%
41%
50%
Short-term Debt
Long-term Debt
Total Interest bearing Liabilities
2004
137
653
789
Equity
Total Capital
50%
789
100%
1579
4. Calculate the firms dollar cost of capital. The prime rate is currently at 7%
per year and the bank charges prime plus 2%. The company is in the 40%
tax bracket. 10-year treasury notes are currently yielding 5% and the risk
premium for Gannons equity is 8%.
After-tax Cost of Debt = Prime rate + bank charges (1-Tax rate)
= (7% + 2%)(1-.4) = 9%(0.6) = 5.4%
Cost of Equity = 10-year Treasury bond yield +Risk Premium
= 5% + 8% = 13%
WACC04 = Weight of Debt*After-tax cost of debt + Weight of Equity*Cost of
Equity
= 0.5*5.4% + 0.5*13% = 9.2%
$ Cost of Capital 04= Total Capital * WACC = $1,578 m *9.2%=$145.26m
5. Calculate the firms EVA for both years. What does it indicate about the
performance of the company?
2004
196
145
51
NOPAT ($ millions)
- $Cost of Capital ($ million)
=EVA
2003
128
130
-2
The EVA is positive and has increased significantly from its negative level in 2003.
This is a sign that the company is adding value for its shareholders and is an
indication of good performance overall.
6. Do your conclusions regarding the firms performance, based on EVA,

concur with those from the ratio analysis? Please explain.
Yes, the conclusions regarding the firms performance made based on EVA are
similar to those made based on the financial ratios. Increasing profit margins
combined with lower debt have helped the company add significant economic value
for its shareholders over the past year.
7. What are the main advantages of using EVA as a performance evaluation
measure?
EVA is a useful yardstick for measuring performance of a firm relative to its
competitors and over time. It indicates the dollar amount of economic value added
(or destroyed) by the firms managers as a result of its operations, after accounting
for all capital costs for the year. It has been shown to be a useful tool for
determining compensation and reward systems for corporations. It is fairly easy to
calculate and is directly linked with the capital structure and capital budgeting
decisions made by managers.

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Solution to Case 22

Economic Value Added (EVA)

EVA Does It Really Work?

3. What are the relative proportions of debt and equity in Gannon

6. Do your conclusions regarding the firms performance, based on EVA,

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