Yesterday, Extensive Enterprise Inc. released its 2018 annual report on the company’s website. While reading the report for his boss, Rafael came across several terms about which he was unsure. He leaned around the wall of his cubicle and asked his colleague, Asha, for help. RAFAEL: Asha, do you have a second to help me with my reading of Extensive’s annual report? I’ve come across several unfamiliar terms, and I want to make sure that I’m interpreting the data and management’s comments correctly. For example, one of the footnotes to the financial statements uses “the book value of Extensive’s shares,” and then in another place, it uses “Economic Value Added.” I’ve never encountered those terms before. Do you know what they’re talking about? ASHA: Yes, I do. Let’s see if we can make these terms make sense by talking through their meaning and their significance to investors. The term book value has several uses. It can refer to a single asset or the company as a whole. When referring to an individual asset, such as a piece of equipment, book value refers to the asset’s ___________ (Market value or replacement cost, historical value or original purchase price), adjusted for any accumulated depreciation or amortization expense. The ________ (net, gross) value, or difference between the machine’s historical cost and its accumulated depreciation expense, is called its book value. In contrast, when the term refers to the entire company, it means the total value of the company’s ________ (shareholders’ equity, total assets) as reported in the firm’s ________ (balance sheet, income statement) . RAFAEL: That makes sense. So, what makes this value important to investors is that it is _________ (a historical, an unexpected future) value that can change—but only due to a couple of events, including the _________ (repurchase, sale) of Treasury stock, the sale of new common or preferred shares, and the payment of ___________ (dividends, interest). Equally important, it ________ (will not, will) change in response to changes in the market prices of the firm’s shares. ASHA: Right! So, how useful would a firm’s book value be for assessing the performance of Extensive’s management? RAFAEL: Well, because Extensive’s book value ___________ (changes, does not change) with changes in the market price of the firm’s shares, the firm’s book value ___________ (Can, Cannot) reflect management’s efforts to maximize the shareholder wealth and therefore ___________ (Should, should not) be used to evaluate management’s performance. Now, what about “Economic Value Added”? ASHA: During the 1990s, the consulting firm Stern, Stewart & Company developed the concept of Economic Value Added, or EVA, to better assess management’s performance in maximizing their shareholders’ wealth. Extensive’s EVA equals the additional profit created in excess of the after-tax operating income necessary to finance its total after-tax cost of capital, which is expressed in annual dollars. It is computed by subtracting Extensive’s _______________ (annual dollar cost of equity, annual dollar cost of capital) from its _____________ (net operating profit after taxes, new income) . In turn, Extensive’s annual cost of capital is calculated by multiplying its total __________ (invetor-supplied, shareholder-supplied) operating capital, which includes its net fixed assets and net operating working capital, by the after-tax percentage cost of capital. OK, given that description, here’s a question for you: Compared to the book value, what is the advantage of using the EVA to evaluate the performance of Extensive’s management? RAFAEL: Give me a second to think. . . OK, it’s better to evaluate the performance of Extensive’s management by using the company’s EVA rather than the book value of its shareholders’ equity because the better the managerial decisions being made, the _________ (less, greater) the after-tax net operating income earned, the ____________ (less, greater) the difference between this net operating income and the cost of capital needed to generate that income, and the _______________ (less, greater) the EVA, or true economic profit, earned by the company. ASHA: Nicely done! Does this make your reading of Extensive’s annual report easier?

Yesterday, Extensive Enterprise Inc. released its 2018 annual report on the company’s website. While reading the report for his boss, Rafael came across several terms about which he was unsure. He leaned around the wall of his cubicle and asked his colleague, Asha, for help. RAFAEL: Asha, do you have a second to help me with my reading of Extensive’s annual report? I’ve come across several unfamiliar terms, and I want to make sure that I’m interpreting the data and management’s comments correctly. For example, one of the footnotes to the financial statements uses “the book value of Extensive’s shares,” and then in another place, it uses “Economic Value Added.” I’ve never encountered those terms before. Do you know what they’re talking about? ASHA: Yes, I do. Let’s see if we can make these terms make sense by talking through their meaning and their significance to investors. The term book value has several uses. It can refer to a single asset or the company as a whole. When referring to an individual asset, such as a piece of equipment, book value refers to the asset’s _______ (Market value or replacement cost, historical value or original purchase price), adjusted for any accumulated depreciation or amortization expense. The (net, gross) value, or difference between the machine’s historical cost and its accumulated depreciation expense, is called its book value. In contrast, when the term refers to the entire company, it means the total value of the company’s (shareholders’ equity, total assets) as reported in the firm’s (balance sheet, income statement) . RAFAEL: That makes sense. So, what makes this value important to investors is that it is _ (a historical, an unexpected future) value that can change—but only due to a couple of events, including the _ (repurchase, sale) of Treasury stock, the sale of new common or preferred shares, and the payment of _ (dividends, interest). Equally important, it (will not, will) change in response to changes in the market prices of the firm’s shares. ASHA: Right! So, how useful would a firm’s book value be for assessing the performance of Extensive’s management? RAFAEL: Well, because Extensive’s book value _ (changes, does not change) with changes in the market price of the firm’s shares, the firm’s book value _ (Can, Cannot) reflect management’s efforts to maximize the shareholder wealth and therefore _ (Should, should not) be used to evaluate management’s performance. Now, what about “Economic Value Added”? ASHA: During the 1990s, the consulting firm Stern, Stewart & Company developed the concept of Economic Value Added, or EVA, to better assess management’s performance in maximizing their shareholders’ wealth. Extensive’s EVA equals the additional profit created in excess of the after-tax operating income necessary to finance its total after-tax cost of capital, which is expressed in annual dollars. It is computed by subtracting Extensive’s _____ (annual dollar cost of equity, annual dollar cost of capital) from its _ (net operating profit after taxes, new income) . In turn, Extensive’s annual cost of capital is calculated by multiplying its total (invetor-supplied, shareholder-supplied) operating capital, which includes its net fixed assets and net operating working capital, by the after-tax percentage cost of capital. OK, given that description, here’s a question for you: Compared to the book value, what is the advantage of using the EVA to evaluate the performance of Extensive’s management? RAFAEL: Give me a second to think. . . OK, it’s better to evaluate the performance of Extensive’s management by using the company’s EVA rather than the book value of its shareholders’ equity because the better the managerial decisions being made, the _ (less, greater) the after-tax net operating income earned, the (less, greater) the difference between this net operating income and the cost of capital needed to generate that income, and the _______ (less, greater) the EVA, or true economic profit, earned by the company. ASHA: Nicely done! Does this make your reading of Extensive’s annual report easier?

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Question

RAFAEL: Asha, do you have a second to help me with my reading of Extensive’s annual report? I’ve come across several unfamiliar terms, and I want to make sure that I’m interpreting the data and management’s comments correctly.

For example, one of the footnotes to the financial statements uses “the book value of Extensive’s shares,” and then in another place, it uses “Economic Value Added.” I’ve never encountered those terms before. Do you know what they’re talking about?

ASHA: Yes, I do. Let’s see if we can make these terms make sense by talking through their meaning and their significance to investors.

The term book value has several uses. It can refer to a single asset or the company as a whole. When referring to an individual asset, such as a piece of equipment, book value refers to the asset’s ___________ (Market value or replacement cost, historical value or original purchase price), adjusted for any accumulated depreciation or amortization expense. The ________ (net, gross) value, or difference between the machine’s historical cost and its accumulated depreciation expense, is called its book value.

In contrast, when the term refers to the entire company, it means the total value of the company’s ________ (shareholders’ equity, total assets) as reported in the firm’s ________ (balance sheet, income statement) .

RAFAEL: That makes sense. So, what makes this value important to investors is that it is _________ (a historical, an unexpected future) value that can change—but only due to a couple of events, including the _________ (repurchase, sale) of Treasury stock, the sale of new common or preferred shares, and the payment of ___________ (dividends, interest). Equally important, it ________ (will not, will) change in response to changes in the market prices of the firm’s shares.

ASHA: Right! So, how useful would a firm’s book value be for assessing the performance of Extensive’s management?

RAFAEL: Well, because Extensive’s book value ___________ (changes, does not change) with changes in the market price of the firm’s shares, the firm’s book value ___________ (Can, Cannot) reflect management’s efforts to maximize the shareholder wealth and therefore ___________ (Should, should not) be used to evaluate management’s performance.

Now, what about “Economic Value Added”?

ASHA: During the 1990s, the consulting firm Stern, Stewart & Company developed the concept of Economic Value Added, or EVA, to better assess management’s performance in maximizing their shareholders’ wealth.

Extensive’s EVA equals the additional profit created in excess of the after-tax operating income necessary to finance its total after-tax cost of capital, which is expressed in annual dollars. It is computed by subtracting Extensive’s _______________ (annual dollar cost of equity, annual dollar cost of capital) from its _____________ (net operating profit after taxes, new income) .

In turn, Extensive’s annual cost of capital is calculated by multiplying its total __________ (invetor-supplied, shareholder-supplied) operating capital, which includes its net fixed assets and net operating working capital, by the after-tax percentage cost of capital.

OK, given that description, here’s a question for you: Compared to the book value, what is the advantage of using the EVA to evaluate the performance of Extensive’s management?

RAFAEL: Give me a second to think. . . OK, it’s better to evaluate the performance of Extensive’s management by using the company’s EVA rather than the book value of its shareholders’ equity because the better the managerial decisions being made, the _________ (less, greater) the after-tax net operating income earned, the ____________ (less, greater) the difference between this net operating income and the cost of capital needed to generate that income, and the _______________ (less, greater) the EVA, or true economic profit, earned by the company.

ASHA: Nicely done! Does this make your reading of Extensive’s annual report easier?

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