Which of the following would be Yip’s most appropriate response to Robinson’s third observation?

Mun Hoe Yip is valuing Pure Corporation. Pure is a simple corporation that is going out
of business in five years, distributing its income to creditors and bondholders as planned in
the financial statements below. Pure has a 19 percent cost of equity, 81
/3 percent before-tax
cost of debt, 12 percent weighted average cost of capital, and 40 percent tax rate, and it
maintains a 50 percent debt/value ratio.
Yip is valuing the company using the basic capital budgeting method as well as other
methods, such as EP, residual income, and claims valuation. Yip’s research assistant, Linda
Robinson, makes three observations about the analysis.
Observation 1: “The present value of the company’s economic income should be equal
to the present value of the cash flows in the basic capital budgeting
approach.”
Observation 2: “The economic income each year is equal to the cash flow minus the
economic depreciation.”
Observation 3: “The market value added is the present value of the company’s
economic profit (EP), which equals the net worth of 77,973.”
Year 0 1 2 3 4 5
Balance Sheets:
Assets 200,000 160,000 120,000 80,000 40,000 0
Liabilities 122,027 107,671 88,591 64,222 33,929 0
Net worth 77,973 52,329 31,409 15,778 6,071 0
Income Statements:
Sales 180,000 200,000 220,000 240,000 200,000
Variable cash expenses 90,000 100,000 110,000 120,000 100,000
Fixed cash expenses 20,000 20,000 20,000 20,000 20,000
Depreciation 40,000 40,000 40,000 40,000 40,000
EBIT 30,000 40,000 50,000 60,000 40,000
Interest expense 10,169 8,973 7,383 5,352 2,827
EBT 19,831 31,027 42,617 54,648 37,173
Taxes at 40 percent 7,932 12,411 17,047 21,859 14,869
Net income before salvage 11,899 18,616 25,570 32,789 22,304
After-tax salvage value 12,000
Net income 11,899 18,616 25,570 32,789 34,304
Statements of Cash Flows:
Operating cash flows:
Net income 11,899 18,616 25,570 32,789 34,304
Depreciation 40,000 40,000 40,000 40,000 40,000
Total 51,899 58,616 65,570 72,789 74,304
26 Learning Outcomes, Summary Overview, and Problems
part-i-02 13 January 2012; 10:13:23
Year 0 1 2 3 4 5
Financing cash flows:
Debt repayment 14,357 19,080 24,369 30,293 33,929
Dividends/repurchases 37,542 39,536 41,201 42,496 40,375
Total 51,899 58,616 65,570 72,789 74,304
Investing cash flows: 0 0000
Total cash flows: 0 0000
A. The market value added is not equal to the present value of EP, although the market value of equity is equal to 122,027.
B. The market value added is equal to the present value of EP, which in this case is 44,055.
C. The market value added is not equal to the present value of EP, and market value added is equal to 44,055.

Answer: B. The market value added is equal to the present value of EP, which in this case is 44,055.