Bisbee Health Products invests heavily in research and development (R&D;), altho
ID: 2521392 • Letter: B
Question
Bisbee Health Products invests heavily in research and development (R&D;), although it must currently treat its R&D; expenditures as expenses for financial accounting purposes. To encourage investment in R&D;, Bisbee evaluates its division managers using EVA. The company adjusts accounting income for R&D; expenditures by assuming these expenditures create assets with a two-year life. That is, the R&D; expenditures are capitalized and then amortized over two years. Western Division of Bisbee shows after-tax income of $8.1 million for year 2. R&D; expenditures in year 1 amounted to $3.9 million and in year 2, R&D; expenditures were $5.3 million. For purposes of computing EVA, Bisbee assumes all R&D; expenditures are made at the beginning of the year. Before adjusting for R&D;, Western Division shows assets of $37.2 million at the beginning of year 2 and current liabilities of $670,000. Bisbee computes EVA using divisional investment at the beginning of the year and a 16 percent cost of capital. Required: Compute EVA for Western Division for year 2. (Enter your answers in dollars, not in millions.) Adjusted divisional income Cost of adjusted divisional investment Economic value added (EVA)Explanation / Answer
Economic Value Added (EVA) for a division should be computed by subtracting the cost of adjusted divisional investment from the adjusted after-tax income from that division.
EVA = Adjusted Divisional Income - (Cost of Capital*Adjusted Divisional Investment)
Adjusted Divisional Income = After Tax income+R&D Exp. written off for year 1+R&D Exp. written off for year 2
= $8,100,000+($3,900,000/2)+($5,300,000/2)
= $8,100,000+$1,950,000+$2,650,000 = $12,700,000
Adjusted Divisional Investment = Total Assets - Current Liabilities
= $37,200,000 - $670,000 = $36,530,000
Cost of Adjusted Divisional Investment = Adjusted Divisional Investment*Cost of capital
= $36,530,000*16% = $5,844,800
EVA = Adjusted Divisional Income - Cost of Adjusted Divisional Investment
= $12,700,000 - $5,844,800 = $6,855,200
Therefore, EVA for Western Division for year 2 is $6,855,200.
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