Colonial Pharmaceuticals is a small firm specializing in newproducts. It is organized into two divisions, which are based onthe products they produce. AC Division is smaller and the life ofthe products it produces tend to be shorter than those produced bythe larger SO Division. Selected financial data for the past yearis shown below. Divisional investment is as of the beginning of theyear. Colonial Pharmaceuticals uses a 9 percent cost of capital anduses beginning-of-the-year investment when computing ROI andresidual income. Ignore income taxes.
ACDivision SODivision 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 Divisionand a nine-year life in the SO division. All R&D expendituresare spent at the beginning of the year. Assume there are no currentliabilities and (unrealistically) that no R&D investments hadtaken place before this year.
Al, the manager of the AC Division, complains that thecalculation of EVA is unfair, because a much longer life is assumedfor the SO Division in calculating EVA. Sean, the manager of SO,responds that EVA is supposed to reflect economic reality and thatthe reality is that R&D investments in SO Division do have alonger life.
Required:
a. Assume that the economic life of R&Dinvestments is two years in the AC Division. What economic lifewould the R&D investments in the SO Division have to make EVAin the two divisions equal?
Colonial Pharmaceuticals is a small firm specializing in newproducts. It is organized into two divisions, which are based onthe products they produce. AC Division is smaller and the life ofthe products it produces tend to be shorter than those produced bythe larger SO Division. Selected financial data for the past yearis shown below. Divisional investment is as of the beginning of theyear. Colonial Pharmaceuticals uses a 9 percent cost of capital anduses beginning-of-the-year investment when computing ROI andresidual income. Ignore income taxes.
| ACDivision | SODivision | |||||
| 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 Divisionand a nine-year life in the SO division. All R&D expendituresare spent at the beginning of the year. Assume there are no currentliabilities and (unrealistically) that no R&D investments hadtaken place before this year.
Al, the manager of the AC Division, complains that thecalculation of EVA is unfair, because a much longer life is assumedfor the SO Division in calculating EVA. Sean, the manager of SO,responds that EVA is supposed to reflect economic reality and thatthe reality is that R&D investments in SO Division do have alonger life.
Required:
a. Assume that the economic life of R&Dinvestments is two years in the AC Division. What economic lifewould the R&D investments in the SO Division have to make EVAin the two divisions equal?
