Chapter 9 Homework Questions

1.What do we mean by financial structure?

Answer.1. The financial structure refers to a mix structure which is made up by
combining equities and debts a company or a firm uses to do it’s operations. In other
words, financial structure is also known as capital structure.

2. What accounts in the statement of financial position are taken into consideration to
calculate the cost of financing?
Answer.2. The accounts taken into consideration to calculate the cost of financing are
assets which include cash, stocks, properties etc. Liabilities which are the things that a
business owes to pay others, which includes loans, leases etc. Equity, it is the amount
which is left over with the owner after deducting the liabilities.
3. What is the meaning of economic value added (EVA)? What does it measure? Why is it
important?
Answer.3. The economic value added (EVA) is the estimated figure of the economic

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profit of a firm. It is the net profit less the capital charge, this is done for raising the
firm’s capital. Basically, EVA is used for measuring the profit or value a company

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generates from the funds and capitals invested in it. It is important because it
indicates the level of profits a company’s project will be producing, as a result it gives

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information management performance.
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4. What is the purpose of calculating the cost of capital?
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Answer.4. Following are the reasons for the calculation of cost capital. The cost of
capital gives the minimum rate of returns it will be getting on the investments. It is one
the important as well as essential part of budgeting decisions. By knowing the cost
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capital, a business or a firm can make better decisions and plans for the benefit and
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profits of their company.

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5. Differentiate between debt financing and common share financing.

Answer.5. Common share financing or common stock financing is a process which
represents sales of stocks if an ownership within the corporation to get cash or capital and
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investments. It has some risks involved that are applicable to owners and management.
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Some of the examples are initial public offering and crowd funding.
Debt financing is the process in which a firm raises money for working capital or capital
expenditures, by selling bonds, notes or bills to an individual or institutional investor. By
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this process the individual becomes a creditor and receive a promised amount and
interests. The main example is loan which include personal loans, banking loans, loans
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from friends and family.

Learning Exercises:
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EXERCISE 1: COST OF CAPITAL

A company wants to raise $50 million to finance the following capital expenditure projects, with their respective rates of return.
Project A 8%
Project B 9%
Project C 10%
Project D 11%

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 Project E 12%
Project F 13%
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The various sources and cost of funds are as follows:
In millions of $ Amounts Cost (after tax)
Common shares $20 14%
Retained earnings 10 10%
Mortgage 10 6%
Bonds 10 7%

Questions
1. What is the company’s cost of capital?

Total Capital = $20+$10+$10+$10 = $50 million


Weight/ proportion of Common shares = $20 million / $50 million = 40%

Weight/ proportion of Retained earnings = $10 million / $50 million = 20%

Weight/ proportion of Mortgage = $10 million / $50 million = 20%


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Weight/ proportion of Bonds = $10 million / $50 million = 20%
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So, the company's cost of capital, (weighted average cost of capital or WACC) is
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given by

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 WACC = 40%*14%+20%*10%+20%*6%+20%*7% = 10.20%

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Company's cost of capital is 10.20%
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EXERCISE 2: COST OF CAPITAL
Daniel and Evelyn are considering buying a house valued at $250,000. They have combined savings of $20,000, and the bank
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approved a $200,000 first mortgage. Another financial institution agreed to provide them with a $20,000 second mortgage. Also,
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Daniel has just won $10,000 from a lottery. If Daniel and Evelyn invested their money in guaranteed certificates, they would be able
to earn 4%. The interest rates offered by the bank are 6% for the first mortgage and 7% for the second.
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Question
Calculate Daniel and Evelyn’s cost of capital.
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 Mortgage of $ 200,000 at 6% interest rate.

 Second mortgage of $20,000 at 7% interest rate.
 Total money = 30,000+200,000+20,000 = $250,000.
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Now, Overall cost of capital is the combined rate of Interest for the total Money.
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 Overall cost of capital can be obtained by multiplying the proportion of each amount to
total money with their interest rate. And add all the interest rates so obtained.
 Proportion of own money = 30,000/250,000 = 0.12
Interest cost of own money in total money = 0.12×4% = 0.48%
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
 Proportion of first Mortgage = 200,000/250,000 = 0.80
 Interest cost of first Mortgage in total money = 0.80×6% =4.8%
 Proportion of Second Mortgage = 20,000/250,000 = 0.08
 Interest cost of Second Mortgage in total money = 0.08×7% = 0.56%

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  Cost of Capital = Adding the Interest rate obtained by (multiplying the proportion of total
money with the respective interest rate)
 Cost of Capital = 0.48 + 4.80 + 0.56 = 5.84%
 The Cost of Capital for $ 250,000 is 5.84%

EXERCISE 3: ECONOMIC VALUE ADDED

Oscar Lewitt, CEO of Ingram Corporation, had just read in a recent issue of Fortune magazine an article entitled “America’s Wealth
Creators” and noticed several names of corporations he was familiar with, such as Microsoft, General Electric, Intel, Walmart, Coca-
Cola, Merck, and Pfizer. These top wealth creators were listed in terms of their market value added (MVA) and economic value added
(EVA). Although he knew that some of the MVA and EVA were in the billions of dollars, he noticed in the article two other numbers,
return on capital and cost of capital. He felt that if these corporations, despite their size, were able to figure out how much value they

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were adding to the wealth of their shareholders, it would be possible to calculate the EVA for Ingram Corporation.

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At his next management committee meeting, Mr. Lewitt asked his controller to calculate the EVA for Ingram Corporation and to
report the information to the management committee at their next meeting for discussion purposes.

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After some research about this new financial technique, the controller knew that he had to refer to his financial statements to

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calculate the EVA. He had to draw several numbers from the statement of income and the statement of financial position to determine
the cost of capital and ROA. The company’s most recent statement of income and different sources of financing are shown below:

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Ingram Corporation Statement of Income For the year ended December 31, 2014
Revenue
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Cost of sales (650,000)
Gross profit 550,000
Expenses
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Distribution costs (150,000)

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Administrative expenses (125,000)

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Depreciation (50,000)

Finance costs (45,000)

Total expenses (370,000)
Profit before taxes 180,000
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Income tax expense (67,500)

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Profit for the year $ 112,500

The company’s three major sources of financing are from short-term lenders for $100,000, a mortgage for $325,000, and equity
for $430,000. The equity portion was split between share capital of $130,000 and retained earnings of $300,000.
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The cost of capital for these three sources of financing is as follows:

• Equity
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• Short-term borrowings
• Long-term borrowings

Questions
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1. Calculate Ingram Corporation’s EVA.

2. Comment on the EVA. How could EVA be improved?

Solution 1

EVA = NOPAT - (Invested Capital * WACC)

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 where EVA = Economic Value Added
NOPAT = Net Operating Profit after Taxes = $ 112,500
Invested Capital = Debt+ Short Term Borrowings + Shareholders Funds = $ 855,000 (From the
table below)

Weighted
Type of Amount Weights or Cost of Cost of
Particulars Capital ($) Proportion Capital Capital

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Share
Capital Equity $130,000 0.15 12.00% 1.80%

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Retained

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Earnings Equity $300,000 0.35 12.00% 4.20%
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Financing
from Short-
Term Short-Term
Lenders Borrowings $100,000 0.12 8.00% 0.96%
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Long-Term
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Mortgage Borrowings $325,000 0.38 7.00% 2.66%

9.62%
Total $ 855,000 1.00 (WACC)
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Weights = Category wise Capital/ Total Capital

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Weighted Cost of Capital = Weights * Cost of Capital

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Therefore, Economic Value Added (EVA) = $ 112,500-($ 855,000*9.62%)

= $ 112,500-$ 82,251
EVA=$ 30,249
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Remark on EVA

EVA was made to evaluate the contrast between the speed of return achieved and cost of
capital. in case we could see EVA, it is positive (>0) which suggests the association is
making monetary worth. The association is working profitably and is extending the

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 financial backers regard. A negative EVA will show that an association isn't making
plenitude to the financial backers from its endeavors and capital duties.

How is it possible that EVA would be improved?

• Expanding the Business Pay: Arrangements Pay can be extended by growing

the expenses or selling a more noteworthy number of stocks. Extending the expenses is
immediate. The association charges more for its things or administrations than earlier.
Simultaneously, we should be careful while managing the interest and supply. Since,
income age is ordinarily uncertain, its less complex for the association to diminish capital
costs.

• Lessening the Capital Costs: Net Capital Costs can be brought somewhere
around diminishing the functioning costs, expanding the negligible productivity by
accomplishing economies of colossal degree or leaving/selling the capital that doesn't
deal with the cost of capital for the explanation that is connected with. An association

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may utilize various strategies to decrease the functioning costs like wrangling with
leasers to acquire minimal effort obligation, wheeling and dealing better terms with

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suppliers, etc in case of achieving economies of colossal extension, the organization
ought to cut down its fringe costs for each irrelevant thing. This can be cultivated by

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appearing at improved techniques for capability or getting to new development, etc.
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