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student accountant
October 2007
 t     e  c h  ni      c  a l     
creating value
‘Economic Value Added’ (EVA™) is a trademark of the SternStewart consulting organisation. Stern Stewart maintains that theimplementation of a complete EVA™-based financial managementand incentive compensation system gives managers both betterinformation and superior motivation to make decisions that willcreate the greatest shareholder wealth in any publicly-owned orprivate organisation.
It is argued that linking performance to profit breeds a short‑termistboom–bust culture. For instance, a firm might adopt a cost minimisationprogramme to increase profits and, to this end, make immediateredundancies. This short‑term decision would most likely triggerproblems in the medium to long‑term for the business. This is one ofthe concerns that EVA™ directly addresses, and the principal successof EVA™ as a performance metric is the link with long‑term wealthmaximisation and discount factor techniques. Studies have shown thatcompanies that adopt EVA™ as a performance measure outperformedtheir peers by 8.5% annually, and for those companies operating in adeclining market this jumps to over 12% per annum.The real benefits are realised when EVA™ is further linked tomanagement compensation packages. In this scenario it was found thatcompanies outperformed their peers by 57% over a five‑year period(Stern Stewart, 2005).Stern Stewart argues that EVA™ is the financial performance measurethat comes closer than any other to capturing the true
profit ofan organisation, and is the performance measure most directly linked tothe creation of shareholder wealth over time. EVA™ is an estimate of theamount by which earnings exceed or fall short of the required minimumrate of return that shareholders and debt holders could get by investing inother securities of comparable risk. The formula is as follows:
EVA = net operating profit after tax - WACC x book value ofcapital employed
economic value added
relevant to ACCA Qualifcation Papers P4 and P5
Stern et al (ed 2001) suggest that ‘when fully implemented’ EVA™ willbe ‘the centerpiece of an integrated financial management system thatincorporates the full range of corporate financial decision making’. It isargued that the following advantages can be gained from the adoption ofan EVA™‑based approach to performance measurement:
profits are shown in the way shareholders count themcompany decisions are aligned with shareholder wealth
a financial measure is used that line managers understandthe confusion of multiple goals is ended. 
Profits, the way shareholders count them
 The capital charge is the most distinctive and important aspect of EVA™.Under conventional accounting, most organisations appear profitable,but many, in fact, are not creating value. A simple example would bethat of a firm deciding to invest $50m cash in a bank account. At aninterest rate of 5% per annum the firm would generate interest of $2.5meach year. In this scenario, the firm will create additional profit, but it isextremely unlikely that this will create any value.Peter Drucker has suggested in a
Harvard Business Review
article,that ‘until a business returns a profit that is greater than its cost ofcapital, it operates at a loss’. This is in spite of the fact that it still paystax as if it had a genuine profit. Drucker observes that such organisationsreturn less to the economy than they consume in resources, and thatinstead of ‘creating’ they are in fact destroying wealth. EVA™ explicitlyrecognises that when managers employ capital they must pay for it in thesame way that they would pay other operating expenses.By taking all capital costs into account, including the cost of equity,EVA™ shows the amount of wealth a business has created or destroyedin each reporting period. In other words, EVA™ represents profit the wayshareholders define it. If the shareholders expect, say, a 10% return ontheir investment, they ‘gain’ only to the extent that their share of after‑taxoperating profits exceeds 10% of equity capital.
Aligning decisions with shareholder wealth
Stern et al (2001) argue that the development of EVA™ coincides withthe increased ‘empowerment’ of managers as decision makers, and is atool to meet the potential agency issues that are created when ownershipand management are separated.It is argued that EVA™ helps managers incorporate two basicprinciples of finance into their decision making. The first is that theprimary financial objective of any company should be to maximise thewealth of its shareholders. The second is that the value of a companydepends on the extent to which investors expect future profits to exceedor fall short of the cost of capital. Stern et al argue that a sustainedincrease in EVA™ will precipitate an increase in the market value ofan organisation. They further suggest that the adoption of an EVA™approach has proved effective in virtually all types of organisation,from emerging growth companies to those organisations involved in‘turnaround’ situations. They believe that the current level of EVA™ isn’twhat really matters since the current performance of an organisation isalready reflected in its share price. It is the continuous improvement inEVA™ that brings continuous increases in shareholder wealth.
A financial measure that line managers understand
 EVA™ has the advantage of being conceptually simple and easy toexplain to non‑financial managers, since it starts with familiar operatingprofits and simply deducts a charge for the capital invested either in thecompany as a whole, or in a business unit, or even in a single plant,office, or assembly line. In addition, EVA™ is closely analogous to theconcept of residual income (RI) which is both widely practised and wellestablished in literature as a measure of divisional performance.By assessing a charge for using capital, EVA™ raises managerialawareness of the need for care in the management of the balance sheetas well as the income statement, and helps them to properly assessthe trade‑offs between the two. This broader, more complete view ofthe economics of a business can have a profound influence on businessperformance. Unlike net present value (NPV) calculations, EVA™ canbe used as an effective performance measure because of its ability tomeasure results periodically. Proponents of EVA™ assert that its useprovides a superior measure of the year‑to‑year value that the businesscreates. Moreover, because EVA™ measures performance in terms of‘value’, it should be the cornerstone of any financial management systemused to set corporate strategy, or to evaluate potential capital investmentdecisions, corporate acquisitions, or performance.
Ending the confusion of multiple goals
Most companies use a confusing array of measures to express financialgoals and objectives. Strategic plans are often based on growth in revenuesor market share. Companies may evaluate individual products or lines ofbusiness on the basis of gross margins or cash flow. Business units maybe evaluated in terms of return on assets or against a budgeted profitlevel. Finance departments usually analyse capital investments in terms ofNPV, but weigh prospective acquisitions against the likely contribution toearnings growth. And bonuses for line managers and business unit headsare typically negotiated annually and are invariably based on a profit plan.The result of such varied standards, goals, and terminology is usuallyincohesive planning, operating strategy, and decision making.EVA™ eliminates this confusion by using a single financial measurethat links all decision making with a common focus, ie ‘How do weimprove EVA™’. EVA™ is the only financial management system thatprovides a common language for employees across all operating and stafffunctions. It allows all management decisions to be modelled, monitored,communicated, and compensated in a single and consistent way –always in terms of the value added to shareholder investment.
Typical adjustments that are required in EVA™ calculations include:
October 2007
student accountant
 t     e  c h  ni      c  a l     
Adjustment to net profit Adjustment to capital employed
Add net capitalised intangibles Add net book value of intangibles Add goodwill written off and Add cumulative goodwill andaccounting depreciation (deduct cumulative depreciation previouslyeconomic depreciation) written offAdd increases in provisions such Add provisions such those in respectas those in respect of bad debts of bad debts and deferred taxand deferred taxAdd back interest on debt capital Add debt to net assets such that itforms part of capital employedIn assessing EVA™, one should recognise that it is an annual measureof performance with a historic perspective. The use of EVA™ representsan attempt to measure whether the management of an entity has usedavailable funds in order to ‘create’ or ‘destroy’ value.Under accounting conventions, retained profits are arrived at onlyafter a significant number of expenses and non‑cash adjustments havebeen made. It is arguable, however, that these might be perceived asbeing similar to investments.Investments in intangibles, such as promotional activities, researchand development, and employee training and development, are writtenoff in the income statement under conventional accounting rules. Each ofthese items could be regarded as constituting discretionary expenditureby management. Thus, in the calculation of EVA™ they would be addedback to capital employed on the premise that such expenditures wouldhave otherwise been available to be paid as dividend, or to reduce thelevel of debt finance employed. Likewise, the amount of expenditure onsuch items would be added to or deducted from the net profit or loss forthe year.In calculating EVA™, depreciation and amortisation during theperiod are added back to the capital employed. This is because, whenthe assets were acquired, the funds expended would otherwise havebeen available to the organisation and could have been returned toshareholders. Under EVA™ principles, it is the historic cost of non‑currentassets (less a charge for economic depreciation) which is deemed tobe the relevant figure, due to the fact that it represents the total fundsexpended by the management.The addition to net profit, of increases in provisions such as baddebts and deferred taxation, emanates from recognition of the needto apply prudence under conventional accounting practices. There isthe tendency to be over‑prudent in the making of provisions whichcould seriously undermine the use of reported profit as a measure ofperformance. From a balance sheet perspective, such over‑prudenceleads to an understatement of the true capital employed within abusiness.The existence of operating leases and other forms of off‑balancesheet financing can create distortions in measuring performance basedon an understated capital base. The addition of such debt instrumentsto capital employed avoids any distortion to calculated EVA™ valuesresulting from management decisions which have affected the capitalgearing of the organisation. Otherwise, an organisation could improve itsEVA™ simply by replacing its equity with such debt capital. One mustbe mindful of the need to add back any interest charged during a periodto net profit; this is not only consistent with the adjustment to capitalemployed, but also avoids the ‘double‑counting’ of interest paid on assetsfinanced by debt capital. In the absence of such an adjustment, interestpaid would have been deducted from profit and again deducted in thecalculation of EVA™.
Value Co (VC):Summary income statements for the year: 
2007 2006$m $m
Revenue 608 520Pre‑tax accounting profit (Note 1) 134 108Taxation (46) (37)Profit after tax 88 71Dividends (29) (24)Retained earnings 59 47Summary balance sheet for the year ending: 
2007 2006$m $m
Non‑current assets 250 192Net current assets 256 208506 400 Financed by:Shareholders’ funds 380 312Medium and long‑term bank loans 126 88506 400Note 1: After deduction of the economic depreciation of the company’snon‑current assets. This is also the depreciation used for tax purposes.Other information is as follows:1 Capital employed at the end of 2005 amounted to $350m.2 VC had non‑capitalised leases valued at $16m in each of the years2005 to 2007. The leases are not subject to amortisation.3 VC’s pre‑tax cost of debt was estimated to be 9% in 2006 and 10%in 2007.4 VC’s cost of equity was estimated to be 15% in 2006 and 17% in2007.5 The target capital structure is 70% equity, 30% debt.6 The rate of taxation is 30% in both 2006 and 2007.
student accountant
October 2007
 t     e  c h  ni      c  a l     

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