Donegal, Inc., has decided to use EVA to evaluate its performance. Last year, Donegal had after-tax operating income of $350,000. Two sources of financing were used by the company: $3 million of mortgage bonds paying 6 percent interest and $9 mil- lion in common stock, which was considered to be relatively more risky than other stocks, and had a risk premium of 8 percent. The rate on long-term treasury bonds is 3 percent. Donegal, Inc., has $4,000,000 in operating assets and pays a marginal tax rate of 40 percent.
Required
1. Calculate the weighted average cost of capital for Donegal, Inc.
2. Calculate EVA for Donegal. Is Donegal creating wealth or not?
Now suppose that Donegal, Inc., is considering borrowing $2,000,000 in unsecured bonds at a rate of 9 percent. The money will be used to purchase additional operat- ing assets of $1,000,000 (making total operating assets of $5,000,000). This added investment will enable the company to manufacture products that are budgeted to increase after-tax operating income by $80,000. (Total after-tax operating income will be $430,000.)
3. Calculate the new weighted average cost of capital for Donegal, Inc.
4. Calculate the EVA for Donegal, Inc., including the new products. Is the new investment a good idea?