Atomic Electronics is considering instituting a plan whereby managers will be evaluated and rewarded based on a measure of economic value added (EVA). Before adopting the plan, management wants you to calculate what EVA will be in 2012 based on financial forecasts for 2012 and prior financial data.
Fiscal Forecast2012
Total assets .......... ......$ 55,000,000
Non interest-bearing current liabilities ......$ 21,000,000
Sales ..................$ 100,000,000
Net income ................$ 5,500,000
Interest expense ..............$ 1,200,000
Research and development .........2,400,000
Tax rate ................35%
Cost of capital ..............14%
Research and development expenditures in 2010 and 2011 were $1,200,000 and $2,100,000, respectively. In calculating EVA, prior research and development will be capitalized and amortized assuming a three-year life (i.e., one-third will be expensed in the year incurred, and two-thirds will be capitalized and expensed in the following two years).
Required:
a. Explain why it is important to capitalize research and development if managers are to be rewarded based on EVA.
b. Calculate forecasted EVA for 2012.
c. Will management be likely to support use of EVA as a financial performance measure?