Reference no: EM132966487

Question: Alexis Lynn is the sole shareholder of Lynn Imaging, which manufactures a variety of medical imaging devices. In early 2016, Lynn hired a new CEO, Paul Stang, who is paid an annual salary of $200,000 plus a bonus of $50,000 if the increase in net income relative to the prior year is greater than 5%.

Dividend policy at Lynn Imaging has been to pay cash dividends on December 31 of each year equal to net income for the year. Stang convinced Lynn that rather than pay dividends of $871,000 at the end of 2016, Lynn Imaging should instead use the cash to acquire Bridger Inc., a small competitor. The acquisition was completed on January 1, 2017.

The weighted average cost of capital (WACC) for Lynn Imaging is 12%. (Lynn Imaging has no interest-bearing debt, so the cost of capital is the cost of equity capital.)

Assume there are no income taxes. Because there are no income taxes and no interest-bearing debt, Net Income = Operating Income = NOPAT.

Balance Sheet:                                                         2016                     2017
Assets: 
           Cash & Accounts Receivable                    200,000                300,000
           Inventory                                                 500,000                800,000
           Goodwill                                                          -0-                371,000
           Factory and Equipment, Net                 4,500,000             4,300,000
           Land                                                     1,000,000             1,000,000
               Total Assets                                      6,200,000             6,771,000
                                                                                                                       
Liabilities:
           Accounts Payable                                     600,000                500,000
           Wages Payable                                         600,000                400,000
                                                                                                                       
Shareholder's Equity                                                                                      
           Common Stock                                     5,000,000             5,000,000
           Retained Earnings                                            -0-                871,000
               Total Liabilities + Equity    6,200,000       6,771,000

Lynn Imaging's operating income in 2017 equaled $923,000. The company had R&D expense (used to develop new imaging technologies) of $200,000 in 2015, $300,000 in 2016 and $0 in 2017 and $0 (estimated) in 2018. For EVA purposes, Lynn believes that R&D provides benefits over 2 years and therefore should be amortized in equal amounts over a 2-year useful life, starting in the year of the expenditure.

Question:
Although Net Income was larger in 2017 than in 2016, Lynn is interested in how the acquisition and other decisions Stang has made have affected the company's overall EVA. Compute EVA for 2016 and 2017. (Hint: The only non-GAAP adjustment you should make is for R&D.)