Question

Colonial Pharmaceuticals is a small firm specializing in new products. It is organized into two divisions, which are based on the products they produce. AC Division is smaller and the life of the products it produces tend to be shorter than those produced by the larger SO Division. Selected financial data for the past year is shown as follows. Divisional investment is as of the beginning of the year. Colonial Pharmaceuticals uses a 8 percent cost of capital and uses beginning-of-the-year investment when computing ROI and residual income. Ignore income taxes. Allocated corp. overhead Cost of goods sold Divisional investment R&D Sales SG&A AC Division $ 670 3,340 10,400 2,700 10,800 910 SO Division $ 1,100 5,600 73,000 3,600 20,000 830 R&D is assumed to have a two-year life in the AC Division and a nine-year life in the SO division. All R&D expenditures are spent at the beginning of the year. Assume there are no current liabilities and (unrealistically) that no R&D investments had taken place before this year. Required: a. Compute EVA for the two divisions. (Do not round intermediate calculations.) AC Division So Division Economic value added

Answer 1

EVA = Net Operating Profit after tax - (Capital employed * Cost of Capital)

To find out NOPAT (Net Operating Profit after tax), Income Statement is prepared as shown below:

Colonial Pharmaceuticals
Statement of Divisional Income
Particulars	AC Division	SO Division
Sales	$ 10,800	$         20,000
Cost of goods sold	$    3,340	$           5,600
Gross Margin	$    7,460	$         14,400
Allocated corp. overheads	$        670	$           1,100
SG&A	$        910	$               830
R&D	$    1,350	$               400
Operating Income / Divisional Income	$    4,530	$         12,070

R&D cost is going to give benefits for more than one year hence it is not fully expense out in current year. For AC division it will give benefit for 2 years hence total cost cost is divided by 2, on the same lines for SO division total cost is divided by 9 years.

As Income tax is to be ignored so Operating Income = NOPAT for current case.

Cost of Capital is 8% as mentioned in question.

Divisional investment is $ 10,400 for AC division & $ 73,000 for SO division. This can also be termed as capital employed

EVA = Net Operating Profit after tax - (Capital employed * Cost of Capital)

EVA for AC division = $ 4,530 - ( $ 10,400 * 8%) = $ 3,698

EVA for SO division = $ 12,070 - ( $ 73,000 * 8%) = $ 6,230