Question

Normandy Instruments 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, Normandy 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.

Aerospace Division of Normandy shows after-tax income of $18.005 million for year 2. R&D expenditures in year 1 amounted to $7.205 million and in year 2, R&D expenditures were $12.005 million. For purposes of computing EVA, Normandy assumes all R&D expenditures are made uniformly over the year. Before adjusting for R&D, Aerospace Division shows assets of $72.005 million at the beginning of year 2 and current liabilities of $1,505,000. Normandy computes EVA using divisional investment at the beginning of the year and a 12 percent cost of capital.

Required:

Compute EVA for Aerospace Division for year 2.

Note: Enter your answers in dollars, not in millions.

Normandy Instruments 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, Normandy 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.

Aerospace Division of Normandy shows after-tax income of $18.005 million for year 2. R&D expenditures in year 1 amounted to $7.205 million and in year 2, R&D expenditures were $12.005 million. For purposes of computing EVA, Normandy assumes all R&D expenditures are made uniformly over the year. Before adjusting for R&D, Aerospace Division shows assets of $72.005 million at the beginning of year 2 and current liabilities of $1,505,000. Normandy computes EVA using divisional investment at the beginning of the year and a 12 percent cost of capital.

Required:

Compute EVA for Aerospace Division for year 2.

Note: Enter your answers in dollars, not in millions.

Adjusted Divisional Income:

Cost of adjusted divisional income:

Economic value added (EVA)

Answer 1

The Economic Value Added (EVA) for the Aerospace Division for year 2 is -$60,000.00, calculated by adjusting the after-tax income for R&D expenditures and subtracting the cost of capital.

Step-by-step explanation:

To compute the Economic Value Added (EVA) for the Aerospace Division of Normandy for year 2, we first need to adjust the after-tax income for R&D expenditures. Since R&D expenditures are treated as assets with a two-year life, we amortize the year 1 expenditures of $7.205 million over 2 years, hence $3.6025 million for year 2, and add the first half of year 2's expenditures, which is $6.0025 million, to obtain a total R&D expense for year 2 of $9.605 million ($3.6025 million + $6.0025 million). The adjusted income is thus $18.005 million - $9.605 million = $8.4 million. The cost of capital at 12% on the division's beginning assets of $72.005 million (less current liabilities of $1.505 million) is $8.46 million ($70.5 million x 12%). Finally, the EVA is the adjusted income minus the cost of capital: $8.4 million - $8.46 million = -$0.06 million, or -$60,000.00.

The cost of adjusted divisional income is essentially the after-tax income minus R&D adjustments, while the Economic value added (EVA) is this adjusted income minus the cost of capital.