College of Business Administration
ADVANCE FINANCIAL MANAGEMENT (FINA 4312)
MVA and EVA
OPTIMUM CAPITAL
STRUCTURE
CASE 3
SUBMITTED BY:
Lujain Hassanein 200700011
Noora Al-Musailem 200700066
FALL 2012-13
Case 3
MVA AND EVA
OPTIMUM CAPITAL STRUCTURE
Wd
D/S
(1-T)rd
Estimated Beta
Cost of Equity
WACC
0%
20%
40%
60%
80%
0.00%
25.00%
66.67%
150.00%
400.00%
4.80%
5.40%
6.00%
6.60%
7.80%
1.20
1.38
1.68
2.28
4.08
13.2%
14.3%
16.1%
19.7%
30.5%
13.20%
12.50%
12.05%
11.83%
12.34%
1. Optimal Capital Structure
The firm’s value is maximized when the optimal capital structure is obtained. 3Z’s
optimal capital structure is 60% debt and 40% equity as shown in the table above.
2. WACC at the optimal capital structure
The firm’s value is maximized when the optimal capital structure is obtained. 3Z’s
optimal capital structure is 60% debt and 40% equity. The firm’s value is highest when the
weighted average cost of capital is lowest. Thus, the weighted average cost of capital at the
optimal capital structure is 11.83% as shown in the table above.
2|Page
3. Market Value Added (MVA)
Shareholder wealth is maximized by maximizing the difference between the market
value of the firm’s stock and the amount of equity capital supplied by investors. 3Z’s MVA is
2,500,000 as shown below; this amount represents the difference between the money that 3Z’s
stockholders have invested in the corporation since its founding including retained earnings
versus the cash they could get if they sold the business.
MVA at 40% Debt and 60% Equity:
Capital Structure
Debt
Equity
Total Capital
Percentage
Amount
40%
60%
100%
500,000
750,000
1,250,000
MVA = Market value of stock - Equity capital supplied by shareholders
MVA = (Shares outstanding x Stock Price) - Total Common Equity
MVA = (100,000 x 30) - 750,000
MVA = 2,250,000
MVA at the optimum capital structure (40% Debt and 60% Equity) assuming total
capital did not change. MVA increased at the optimum capital structure.
Capital Structure
Debt
Equity
Total Capital
Percentage
Amount
60%
40%
100%
750,000
500,000
1,250,000
MVA = Market value of stock - Equity capital supplied by shareholders
MVA = (Shares outstanding x Stock Price) - Total Common Equity
MVA = (100,000 x 30) - 500,000
MVA = 2,500,000
3|Page
4. Economic Value Added (EVA)
Economic Value Added focuses on managerial effectiveness in a given year. It is an
estimate of a business’s true economic profit. 3Z’s EVA is 8,852,100; this represents the residual
income that remains after the cost of all capital including equity capital has been deducted.
Capital Structure
Debt
Equity
Investor Supplied Operating Capital
Percentage
Amount
40%
60%
100%
500,000
750,000
1,250,000
EVA = Net operating profit after tax (NOPAT) - after-tax dollar cost of capital used to support operations
EVA = EBIT(1-tax) - (Total net operating capital)(WACC)
EVA = 15,000,000(1-40%) - (1,250,000) (11.83%)
EVA = 8,852,100
5. MVA versus EVA
MVA measures the effects of managerial actions since the beginning of the company;
EVA focuses on managerial effectiveness in a given year. If the objective is to measure
managerial performance EVA is preferred because EVA shows the value added during a given
year whereas MVA shows the value added since the beginning of the company. The manager is
evaluated only based on the year he is in charge of the business. Also, EVA can be used to
evaluate the performance of a division or a business unit whereas MVA is used to measure the
performance of the company as a whole.
4|Page
ADDENDUM
1. Computation of the After-Tax Cost of Debt. (The marginal tax rate for the firm is 40%)
Before Tax Cost of Debt, rd
8%
9%
10%
11%
13%
After-Tax Cost of Debt,(1-T)rd
8% x ( 1 -.40) = 4.8%
9% x ( 1 -.40) = 5.4%
10% x ( 1 -.40) = 6.0%
11% x ( 1 -.40) = 6.6%
13% x ( 1 -.40) = 7.8%
2. Computation of Levered Beta (B) = bu[1+(1-T)(D/S)]
Unlevered Beta = 1.20
Wd
0.00
0.20
0.40
0.60
0.80
D/S
0.00
0.25
0.67
1.50
4.00
Beta Estimate
1.20
1.20 [ 1+(1-.40)(25%) = 1.38
1.20 [ 1+(1-.40)(66.67%) = 1.68
1.20 [ 1+(1-.40)(150.00%) = 2.28
1.20 [ 1+(1-.40)(400.00%) = 4.08
3. Computation of Cost of Equity Rs = rf + β (Rm – rf)
Risk Free Rate = 6%, Risk Premium = 6%
Wd
0.00
0.20
0.40
0.60
0.80
5|Page
Estimated Beta, b
1.20
1.38
1.68
2.28
4.08
Cost of Equity Rs
6% + 1.20 (6%) = 13.2%
6% + 1.38 (6%) = 14.3%
6% + 1.68 (6%) = 16.1%
6% + 2.28 (6%) = 19.7%
6% + 4.08 (6%) = 30.5%
4. Computation of Weighted Average Cost of Capital (WACC)= Wcers + wdrd(1-T)
Market debt to
After tax cost
Market equity to
Cost of
Weighted Average
value ratio (Wd)
0.00
0.20
0.40
0.60
0.80
of debt (1-t)rd
4.8%
5.4%
6.0%
6.6%
7.8%
value ratio (We)
1.00
0.80
0.60
0.40
0.20
Equity
13.20%
14.28%
16.08%
19.68%
30.48%
Cost of Capital
13.20%
12.50%
12.05%
11.83%
12.34%
6|Page