Question

Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace Division, after-tax divisional income was $680,000 in year 3.

The company adjusts the after-tax income for advertising expenses. First, it adds the annual advertising expenses back to after-tax divisional income. Second, the company managers believe that advertising has a three-year positive effect on the sale of the company’s products, so it amortizes advertising over three years. Advertising expenses in year 1 will be expensed 50 percent, 35 percent in year 2, and 15 percent in year 3. Advertising expenses in year 2 will be expensed 50 percent, 35 percent in year 3, and 15 percent in year 4. Advertising expenses in year 3 will be amortized 50 percent, 35 percent in year 4, and 15 percent in year 5. Third, unamortized advertising expenses become part of the divisional investment in the EVA calculations. Wallace Division incurred advertising expenses of $182,000 in year 1 and $332,000 in year 2. It incurred $392,000 of advertising in year 3.

Before considering the unamortized advertising, the Wallace Division had total assets of $7,100,000 and current liabilities of $1,060,000 at the beginning of year 3. Biddle Company calculates EVA using the divisional investment at the beginning of the year. The company uses a 10 percent cost of capital to compute EVA.

Required:

Compute the EVA for the Wallace Division for year 3.

Is the division adding value to shareholders?

• Yes

• No

Answer 1

Part 1

Adjusted divisional income	$732500
Cost of adjusted divisional investment	623330
Economic Value Added (EVA)	$109170

After­tax income		680000
Add back advertising expense for year 3		392000
		$1072000
Less amortization of advertising:
Year 1 advertising: 15% × $182,000	27300
Year 2 advertising: 35% × $332,000	116200
Year 3 advertising: 50% × $392,000	196000	339500
Adjusted divisional income		$732500
Divisional investment (total assets of $7100000 – current liabilities of $1060000)		6040000
Unamortized advertising at the beginning of year 3:
From year 1 advertising: 15% × $182,000	27300
From year 2 advertising:(100% – 50% amortized in year 2) × $332,000	166000	193300
Adjusted divisional investment		6233300
Calculation of EVA:
Adjusted divisional income		732500
Cost of adjusted divisional investment (6233300*10%)		623330
EVA		$109170

Part 2

Yes

Because EVA is positive.