 Hello, and welcome to the session in which we would look at economic value added, also known as EVA. Economic value added is a different form of something that we learned about prior, which is called residual value or RI. So it's very important if you don't understand what the residual value is, it's beneficial if you go to the prior recording and view it, otherwise I'm going to be explaining residual value very briefly before we start. Also, before we start, I would like to remind you that if you are an accounting student or especially if you are a CPA candidate, I strongly suggest you check out my website. If you are a CPA candidate and you're taking a CPA course such as Becker, Roger, Wiley, Gleim, I don't replace those courses. What I can be is I can be a useful addition, like a supplement, like a vitamin to your studies, and I can add 10 to 15 points to your CPA score by helping you understand the material better. I teach you the material from scratch in contrast to your CPA review course. So here's my offer to you. Are you willing to risk $30 to try it for a month to find out whether my website and my resources can help you improve your performance on the CPA exam? If not for anything, check out my website to find out how well is your university doing on the CPA exam. I have scored by university as well as section. I do also have other accounting finance tax and audit courses. Please connect with me on LinkedIn if you haven't done so. Check out my LinkedIn recommendation like this video on YouTube and share it. It doesn't cost you anything. Connect with me on Instagram and Facebook. So when we spoke about residual income, one of the disadvantages of residual income was that the required rate of return might be chosen unreasonably or at a wishful rate or arbitrarily. So the required rate of return could be too high. And as a result, managers might make the wrong decision by not selecting certain project. Why? Because the company set up this required rate of return too high. So economic value added is a different form of residual income. Basically, the computation is basically the same. We're going to be using different terms, but it's a remedy to this problem, to this high required rate of return. So it's a remedy for this unrealistic required rate of return. So how do we compute residual income? Simply put, we take after tax income, then we compare after tax income, the difference between after tax income and the required rate of return times the divisional asset. So if our after tax income is 10,000 and this whole parentheses happens to be 8,000, well, we have 2,000 of residual income. And this is based on the required rate of return. So simply put, to be more specific, I'm assuming here we have 80,000 of division assets and the required rate of return is 10%, gives us 8,000. So that's basically residual income. What's going to happen is when we compute economic value added, the same concept with slight adjustments. So rather than using after tax income, we're going to be using adjusted. We're going to make some adjustments to income. Rather than using the required rate of return or all the hurdle rate, we're going to use something called WAC, weighted average cost of capital. I'm going to be defining those in a moment. And we're going to multiply by not the division's asset, it's the adjusted invested asset. We're going to start with the division asset that we're going to make small adjustments. Simply put, we're going to make an adjustment to income, an adjustment to the required rate of return, an adjustment to division asset to find out what's either is the economic value added. Simply put, basically the idea it's the same thing as residual income. Okay. So what do we, what type of adjustments do we make to income? Where we're going to eliminate what we called in quote, accounting distortion. Like what? For research and development, what we do for research and development gap, when we have research and development, we expense research and development, we assume they have no future benefit, therefore they get expensed. If we have any research and development, what we do is we don't treat them as an expense, we treat research and development for the purpose of Eva as assets. Then we depreciate them little by little. But initially, what's going to happen is what we expense, it's going to come back and increase our net income, because we're going to be removing the expense and moving it to the balance sheet. Then we're going to expense a little bit of it. But initially, it's going to increase our income. Same thing with advertising. When you advertise for gap purposes, you expense. And what's going to happen is we're not going to expense it. We're going to take, we're going to take this advertising and add it back to remove it from expense, which means adding to our income. Then we're going to amortize it in pieces over the life. So this these are the basic adjustments for the income. For invested assets, if we have any current liabilities, we'll deduct the current liabilities from invested asset. And we have to compute what we called WAC, the weighted average cost of capital. Remember the required rate of return, that's basically, that's the hurdle rate. That's basically the company can set that rate. Now we're not going to go with that. We're going to go based on the actual form capital structure. Basically, we're going to look at our debt. We're going to look at our equity. How are we financed? Then we're going to find out how much does it actually cost us? Cost us in terms of capital structure between debt and equity. So the best way to let's illustrate WAC first, because it has some computation. Now in a managerial accounting or a cost accounting course, you rarely have to compute WAC, the weighted average cost of capital. But nevertheless, I'm going to go ahead and show you how we compute the weighted average cost of capital. Usually, it will be given to you. But let's assume a company is financed through the following. They have notes, which is loans. They have bonds, which is loans, and they have common stock. And I made the number 6 million for a note. They have a loan for 6 million, 5%. They have bonds, also the form of borrowing of 8 million, which is they're paying 6%, and 14 million in common stock. So 28 million is the total capital. And what we have to find first is the weight of each one. So first, we compute the weight. How much does the note represent of the total capital structure? If we take 6 divided by 28 or 6 million divided by 28 million, 21.5 will do the same thing for the bonds, 8 divided by 28, which is 28.5. And for the common stock, 14 divided by 25. Our tax rate for the purpose of this example is 20%. Then what we do is we find, we're going to take the weight. Notice first, we compute the weight. This is the weight for the note. We're going to take the weight and multiply it by the interest rate, which is 5% on that loan. However, because it's a loan, we get a tax deduction. So what we do is we don't multiply it by 5%. We want to find out what is our net cost of debt. So the bank is charging us 5%. That's fine. That's fine. Let's assume we have $1,000 in a loan times 5%. We pay per year $50. Okay, that's the bad news. That's the bad news. We pay $50. The good news is when we are computing our income minus expenses, what's going to happen? We're going to deduct this $50. Well, if we deduct this $50, this is going to reduce our taxes by $50 times the tax rate. The tax rate is 0.2, which is $10. So simply put, we paid $50 to the bank. As a result of this, we saved $10 on our taxes. So what is our net tax? Minus $50 plus $10. So we end up paying net of tax $40. $40 divided by $1,000, really our net rate is 4%. So I showed you the math. Now, how do you compute this automatically? You will take your bank rate, which is 5%. You multiply it by 1 minus the tax rate. So this is 0.2 is the tax rate. So simply put, you are being charged 5%, but you're going to save 20% on the amount that you spend on interest, which is $50. So simply put, your rate, it's going to be your tax rate times 1 minus the tax rate, which is 0.8. Your net cost for the debt is 0.4, or 0.04, not 0.4, 0.04, or 4%. So the net cost is only 4%. Simply put, to go from the interest cost to the net cost, you'll take the interest cost, which is 5%, you multiply it by 1 minus the tax rate, whatever that tax rate could be 0.4, could be 0.3, could be 25, it doesn't matter, 1 minus the tax rate, you'll get the net cost. So we have to do this for the notes. We also have to do this for the bonds, because at bonds, we have to pay interest on the bonds. Same concept. The weight of the bond is 28.5%. We multiply this by 6% times 1 minus the tax rate. Again, the bonds, we have to pay interest on the bond, which is basically taking 6% multiplied by 0.8, which is the net cost is 0.48. So although we're paying 6%, with the tax savings, we end up paying 4.8%. Now for the stocks, you don't get a tax deduction. You have 50% coming from the stocks, multiplied by 12%. Notice you don't have any tax deduction, because when you pay dividend, you don't get a tax deduction. Dividend is not an expense, therefore, it's 0.06. Now you add up all of them, you add up this, this, and this. So your weighted average cost of capital is 8.16. So this way, managers don't receive a required rate of return that's arbitrary. We use the WAC, and the WAC is based on our actual financing, which is 8.16. The best way to illustrate this is to work a quick example. But again, just don't worry about the WAC that much. Just know what it is, how it's computed. But in a managerial accounting course or a cost accounting, you don't have to do it. Let's take a look at this example. We have universal electronics, which started operation a year ago, has two divisions, a consumer division, and a commercial division. Both divisions are heavily invested in research and development, which is assumed to generate benefit for five years. R&D spending is made uniformly throughout the year. It means, let's assume they spend, for example, $1,000. It means divide that by 12, and they spend one 12 of it every month. Universal electronics has a cost of capital of 11%. That's the cost of capital selected, which is cost of capital is the same thing as WAC. Simply here, cost of capital. It's already computed for you. Selected financial statements are as follows. Compute EVA or Compute Economic Value added for this company. Now again, what do we have to do? Well, let's start with the formula. What's the formula? Well, we have to take adjusted income, which is we don't know what adjusted income. We have divisional income. We're going to take adjusted income divided by adjusted investment. So simply put, we're going to look at adjusted income and we're going to divide by, let's put adjusted investment here. Adjusted assets or adjusted investments, which is the assets. We're going to take those two numbers, divide them by each other, and that's going to give us, once you divide them, that's going to give us economic value added. Now we have to compute adjusted income for the consumer division. Well, we are starting with, they're telling us, our income is $3,850. Remember, this is accounting income. This is accounting income. What do we have to do? Well, simply put, to get to this $3,850, to get to this $3,850, at some point, we deducted $1,000 in R&D. Notice there's $1,000 of R&D research and development. So we deducted $1,000 in R&D to get to this divisional income, to get to this divisional income. So what do we have to do? Now that $1,000 in R&D, we have to add it back because under EVA, we don't expense R&D. We're going to add it back to assets, make it as an asset, and we're going to expense it over the life of the project. So simply put, so we're going to start $3,850, and we're going to add to it $1,000, that's fine. Then guess what? Then we have to deduct the depreciation, the amortization for this R&D because remember, R&D get amortized, just like depreciation, it gets depreciated. Now you might say, okay, then I'll have to deduct $200 because over five years. They're telling us here that they spend the money uniformly throughout the year. It does not mean that they spend $1,000 right from the get-go, they spend it evenly. It means on average, they had a $500 expense in R&D on average. Therefore, you will take $500 divided by five and for the first year, you will deduct $100 for the R&D. Therefore, all in all, the adjusted income for the consumer division is $4,750. So notice we added back the full R&D, then we deducted $100. Simply put, we added back 90% of the R&D. Now for the adjusted investments, we are starting with how much? We are starting with $27,500. Remember, we have to deduct current liabilities. We have to deduct this $1,000 current liabilities gets deducted. Then remember, since we did not expense $900, remember, initially we expensed $1,000, then we took this $1,000, turned it back into a non-expense, then deducted $100 of it into an expense. Now the difference here, this $900 has to go somewhere. This is no longer an expense. If it's no longer an expense, it's added to our asset because now this R&D is capitalized. Now I have my adjusted capital, which is if we do the computation, it's $27,400. Now we can compute economic value added. How do we compute economic value added? Well, we look at our adjusted income, which is $4,750, and we're going to subtract from it 27,400 times, which is 11%. Our WAC is 11%. When we take the difference between those two, we're going to come up to 1,736. This is the economic value added. It's adjusted income minus the adjusted asset or the adjusted invested asset multiplied by the WAC. We can do the same thing for the commercial division. First, we start with the divisional income, which is $3,880. Same concept, we're going to add simply put, we're going to add $1,000, then deduct $100, so simply put, we're going to add $900 here. Then with the divisional asset, we're going to start with this deduct $800, then add $900, because whatever we did not expense, this $900 goes into the asset, and we compute the, and if you want to verify this yourself, the answer should be 1,721.50, if you want to verify to do this computation yourself. So this is how we compute economic value added. 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