Page 76 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

Let us illustrate the above by way of an example. M Co Ltd. Balance Sheet and Profit & Loss Notes
Account is given below:
` in million

Balance Sheet as on 31-3-20X0 Profit and Loss Statement for the year
ending as on 31-3-20X0
Liabilities Assets Net sales 300
Equity 100 Fixed assets 140 Cost of goods sold 258
Debt 100 Net current assets PBIT 42
60 Interest 12
200 200 PBT 30
Tax (30%) 9
PAT 21

Further information provided:
1. Cost of equity 18%; Interest rate on debt 12%
2. Marginal tax rate 30%

Solution:
Post tax cost of debt is 12  (1 – 0.3) = 8.4 %
M employs debt and equity in equal proportion hence weighted average cost of capital is:
0.5  18 + 0.5  8.4 = 13.2 %

M Cos net operating profit after tax is = PBIT (1 – Tax rate) = 42 (1 – 0.3) = ` 29.4 million
And return on capital works out to 29.4 / 200 = 0.147 or 14.7 per cent
M Co's EVA can be worked out in the above four different yet equivalent ways:
1. EVA = Net operating profit after tax-cost of capital  economic book value of the capital
employed in the firm.= 29.4 – 13.2%  200 = 29.4 – 26.4 = ` 3.0 million
2. EVA = Economic book value of the capital employed in the firm ( return on capital – cost
of capital) = 200 (14.7 – 13.2) = ` 3 million
3. EVA = [Profit after tax + Interest (1-marginal tax rate of the firm)] – cost of capital 
economic book value of the capital employed in the firm.= [21 + 12(1 – 0.30)] – 13.2% x 200
= 29.4 – 26.4 = ` 3 million
4. EVA = Profit after tax – cost of equity  equity employed in the firm = 21 – 18  100 = ` 3
million

4.8.2 Three Components of EVA

Net Operating Profit after Tax = Profit before interest and taxes ( 1 – tax rate)
This definition is based on two principles: (i) Separate the investment and financing side of a
firm. This implies that financing charges like interest and dividend are not considered when we
look at profits or cash flows on the investment side. Financing charges will be reflected in the
cost of capital figure used for discounting the profits or cash flows on the investment side. (ii) all
analyses are to be done on post-tax terms.

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