XYZ Company earned operating income of $1,500,000 before income taxes. Capital employed equaled $10,000,000, of which $1,000,000 of mortgage bonds paying 8 percent interest, $3,000,000 unsecured bonds paying 9 percent interest, and $6,000,000 common stock with 10 percent risk premium. The rate on long-term treasury bond is 5 percent. The marginal tax rate is 40%. Calculate the economic value added. Is the company creating or destroying wealth?

The answer is creating wealth, with the economic value added is $390,000

Explanation:

The company WACC is: Percentage of mortgage bond in capital employed x Cost of mortgage bond x (1 - tax rate) + Percentage of unsecured bond in capital employed x Cost of unsecured bond x (1 - tax rate) + Percentage of common stock in capital employed x cost of common stock

In which: Percentage of mortgage bond in capital employed = 1,000,000/10,000,000 = 10%

Percentage of unsecured bond in capital employed = 3,000,000/10,000,000 = 30%;

Percentage of common stock in capital employed = (10,000,000 - 1,000,000 - 3,000,000) / 10,000,000 = 60%

Cost of common stock = Risk free rate + Risk premium = 10% + 5% = 15%;

Tax rate = 40%

Thus, WACC = 10% x 8% x (1 - 40%) + 30% x 9% x (1-40%) + 60% x 15% = 11.10%.

Thus, Capital cost per year: Capital employed x WACC = 10,000,000 x 11.10% = $1,110,000.

Economic value added = Operating Income - Capital cost = 1,500,000 - 1,110,000 = $390,000.