I came across this problem in a the CFAI mock today (2nd mock, AM session)…
Kim believes that analyst forecasts are too pessimistic with respect to DongSun’s residual income prospects after 2014. In a recent conference call, DongSun’s management presented its plan to improve future profitability, particularly the economic value added (EVA), by focusing on the following three strategic company goals:
Adjust financial leverage to the optimal level.
Implement efficiencies in administrative functions.
Reduce research and development (R&D) expenses.
Q. Which of management’s three strategic goals will least likely result in a higher EVA for DongSun?
Goal 1
Goal 2
Goal 3
The answer is 3- reducing R&D. can someone explain how this is accounted for? is it added back to NOPAT? Further, if NOPAT is just EBIT after tax, then wouldnt adding back R&D just negate it, making the actual amount not matter?
Leverage wouldn’t affect EBIT because EBIT is before subtracting interest. Admin efficiency may affect EBIT, although they might be qualitative efficiencies. R&D, if expensed, would reduce EBIT because it is subtracted from arriving at EBIT. R&D isn’t added back to NOPAT. Think of it as (operating profit - R&D - depreciation and amortization) * (1-T)
Sorry, but this explanation is completely incorrect. The question is asking for the goal that least likely results in higher EVA.
As we know, EVA is defined as NOPAT - WACC(capital).
Goal #1: Adjust financial leverage to optimal level - by adjusting to optimal level, we are lowering WACC which results in a higher EVA. So it isnt goal #1 because we are looking for the least likely.
Goal #2: Implement efficiencies in admin functions - by making admin functions efficient, we are reducing expenses. Reducing expenses increase EBIT which increases NOPAT. Since we are looking for the least likely, the answer isn’t goal #2
Goal #3: Reducing R&D expense - This is a trick question. For performance evaluation purposes, EVA makes adjustments for costs that are considered to be accounting distortions by treating them as if they are capitalized assets instead of the GAAP-mandated treatment as expenses. Typically, reducing R&D expense will reduce expense which will increase EBIT/NOPAT. However, the definition of EVA requires R&D to be capitalized rather than expense. See reading 33 (2.2. Commercial Implementations) “Research and development (R&D) expenses are capitalized and amortized rather than expensed (i.e., R&D expense, net of estimated amortization, is added back to earnings to compute NOPAT).” For that reason, because we already added R&D back to NOPAT, removing the expense WILL least likely increase EVA.