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 below. Divisional investment is as of the beginning of the year. Colonial Pharmaceuticals uses a 9 percent cost of capital and uses beginning-of-the-year investment when computing ROI and residual income. Ignore income taxes.

	AC Division			SO Division
Allocated corp. overhead	$	600		$	1,800
Cost of goods sold		3,200			7,000
Divisional investment		9,000			80,000
R&D		2,000			3,600
Sales		8,000			20,000
SG&A		700			1,530

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.

Al, the manager of the AC Division, complains that the calculation of EVA is unfair, because a much longer life is assumed for the SO Division in calculating EVA. Sean, the manager of SO, responds that EVA is supposed to reflect economic reality and that the reality is that R&D investments in SO Division do have a longer life.

Required:

a. Assume that the economic life of R&D investments is two years in the AC Division. What economic life would the R&D investments in the SO Division have to make EVA in the two divisions equal?

Answer 1

EVA for AC Division
Net income = Sales - (Cost of goods sold+allocated corp. overhead+SG&A+R&D)
= 8000 - (3200+600+800+1000)
= 8000-5600
= 2400
Capital investment = Divisional investment + R&D
= 9000+1000
=10000
EVA = 2400 - (10000x9%)
= 2400-900
= 1500
EVA for SO Division
Net income = Sales - (Cost of goods sold+allocated corp. overhead+SG&A+R&D)
= 20000 - (7000+1800+1530+400)
= 20000 - 10730
= 9270
Capital investment = Divisional investment + R&D
= 80000+3200
=83200
EVA = 9270 - (83200x9%)
= 9270-7488
= 1782
Now, we want EVA for SO division to be also 1500
for this we need to amortize R&D expenditure,
we assume we amortize x R&D expenditure
1500 =( Net income - Amortized R&D)-( (Divisional Investment+Unamortized R&D) * 9%)
1500 = (9670 - x)-((80000+3600-x) * 9%)
1500 = 9670 -x -( (83600-x)*9%)
1500 = 9670- x - 7524 + 0.09x
1500 = 2146 - 0.91x
0.91x = 2146-1500
x = 646/0.91
x = 710
P = 3600/710 = 5 years