PROBLEM 12-8. EVA Phillips 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 2006 based on financial forecasts for 2006 and prior financial data.

Forecast Fiscal 2006 Total assets $54,000,000 Noninterest-bearing current liabilities 20,000,000 Sales 98,000,000 Net income 5,000,000 Interest expense 1,000,000 Research and development 2,100,000 Tax rate 35%

Cost of capital 14%

Research and development expenditures in 2004 and 2005 were $600,000 and $1,500,000, 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 2006.

c. Will management be likely to support use of EVA as a financial performance measure?