Potomac Electric uses EVA to evaluate the performance of its two divisions. Following are the details:

Atlantic Division Pacific Division

Total Assets $1,000,000 $5,000,000

Current Liabilities 250,000 1,500,000

Operating Income 200,000 750,000

Potomac has a long-term debt of $3,500,000 at an interest rate of 12% and an equity capital of 3,500,000 at a cost of equity of 14%. Income tax rate is 40%.

Required:

1.Calculate the EVA for both divisions. What are the potential problems in the measurement of EVA and using EVA to compare these two divisions?

2.James Chen, the chairman of Potomac, is considering one of four alternative ways to compensate division managers.

Pay each division manager only a flat salary and no bonus.

Make all of each division managers compensation depend on EVA.

Make all of each division managers compensation depend on companywide EVA rather than division EVA.

Use benchmarking and compensate each division manager on the basis of his or her own divisions EVA minus the EVA of the other division. Assume the two divisions have comparable levels of investment and required rates of return.

Assume that division managers are risk averse and do not like bearing risk. Evaluate each of the four alternatives Chen is considering. Indicate the positive and negative features of each proposal.

Do you see any problems with evaluating only financial performance? How do you propose to overcome the problems? Describe your approach.

Assume that the Atlantic division had expensed all R&D expenses of $ 90,000, 120,000 and 150,000 in the last three years. Assuming an amortization period of 3 years, calculate the EVA if R&D expenses were to be capitalized.