Question

Benchley Company has an extremely simple capital structure with no liabilities (neither interest-bearing nor non-interest-bearing) so Total Assets = Owners’ Equity.

The weighted average cost of capital (WACC) for Benchley is 10%.

Benchley has no income tax expense, i.e., the income tax rate is 0%.

During years 1-4, Benchley made the expenditures on R&D shown in the first line of the table below. The next five lines of the table show a highly condensed GAAP income statement for each year. (Note that consistent with GAAP, the R&D expense in the income statement for each year is equal to the expenditure on R&D.)

The final 2 lines show a highly condensed GAAP balance sheet as of the end of each year:

                                                                   Year 1             Year 2             Year 3             Year 4

R&D expenditures                                   1,400,000        1,500,000        1,600,000        1,300,000

Revenue                                                 10,000,000      10,000,000      10,000,000      10,000,000

–Operating Expenses not R&D               7,000,000        7,000,000        7,000,000        7,000,000

Operating Income Before R&D               3,000,000        3,000,000        3,000,000        3,000,000

–R&D Expense                                        1,400,000        1,500,000        1,600,000        1,300,000

Operating Income (=NOPAT)                 1,600,000        1,500,000        1,400,000        1,700,000

Beginning Total Assets                            20000000      21,600,000      23,100,000      24,500,000

Beginning Total OE                                 20000000      21,600,000      23,100,000      24,500,000

For EVA purposes, Benchley has determined that GAAP should be adjusted by capitalization of R&D expenditures, followed by amortization over a 3-year period, with the first year of amortization in the year of the expenditure and the remainder in the two subsequent years.

For years 3 and 4, calculate adjusted NOPAT and adjusted beginning and ending investment. Investment can be calculated either

i)    directly as owners’ equity plus interest bearing debt (which in this example with no debt is just owners’ equity), or

ii)   indirectly as total assets less non-interest bearing debt (which in this example with no interest-bearing debt is just total assets).

Use adjusted NOPAT and investment amounts to calculate EVA for years 3 and 4.

Answer 1

Calculation of Adjusted NOPAT	Year 1	Year 2	Year 3	Year 4
R&D expenditure	$ 14,000,000.00	$ 15,000,000.00	$ 16,000,000.00	$ 13,000,000.00
Revenue	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00
Operating expenses (Not R& D)	$   7,000,000.00	$   7,000,000.00	$   7,000,000.00	$   7,000,000.00
Operating Income(=NOPAT)	$   3,000,000.00	$   3,000,000.00	$   3,000,000.00	$   3,000,000.00
Less:R&D Expense amortized (See note)	$      466,666.67	$      966,666.67	$   1,500,000.00	$   1,466,666.67
Adjusted NOPAT	$   2,533,333.33	$   2,033,333.33	$   1,500,000.00	$   1,533,333.33
Calculation of R& D expense to be amortized	Year 1	Year 2	Year 3	Year 4
Expense During year	$   1,400,000.00	$   1,500,000.00	$   1,600,000.00	$   1,300,000.00
1/3 in 1st Year	$      466,666.67	$      500,000.00	$      533,333.33	$      433,333.33
1/3 in 2nd Year		$      466,666.67	$      500,000.00	$      533,333.33
1/3 in 3rd year			$      466,666.67	$      500,000.00
Expense to be amortized	$      466,666.67	$      966,666.67	$   1,500,000.00	$   1,466,666.67
Expense to be capitalized	$      933,333.33	$   1,466,666.67	$   1,566,666.67	$   1,400,000.00
Calculation of adjusted beginning and ending investment
	Year 1	Year 2	Year 3	Year 4
Beginning Total OE	$ 20,000,000.00	$ 22,533,333.33	$ 24,566,666.67	$ 26,066,666.67
Add: NOPAT	$   2,533,333.33	$   2,033,333.33	$   1,500,000.00	$   1,533,333.33
Ending Investment	$ 22,533,333.33	$ 24,566,666.67	$ 26,066,666.67	$ 27,600,000.00
WACC = 10%
EVA - Economic Value Added = Nopat - (WACC x Investment(beginning of year))
Year 3	Year 4
$                                                           (956,666.67)	$ (1,073,333.33)