Chapter 14, Problem 51P

Economic Value Added

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 $7.5 million for year 2. R&D expenditures in year 1 amounted to $3 million and in year 2. R&D expenditures were $4.8 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 $30 million at the beginning of year 2 and current liabilities of $600,000. Bisbee computes EVA using divisional investment at the beginning of the year and a 14 percent cost of capital.

Required

Compute EVA for Western Division for year 2.