Study Pack 40 EVA MVA

In corporate Finance Economic Value Added or EVA, a registered trademark of Stern Stuart is an estimate of a
firm's economic profit- being the value created in excess of the reuired return of the compan!"s investors
#being shareholders and debt holders$% &uite simpl!, EVA is the profit earned b! the firm less the cost of financing
the companies capital% 'he idea is that value is created (hen the return on the firm's economic capital emplo!ed is
greater than the cost of that capital% 'his amount can be determined b! making ad)ustments to *AA+ or
IF,S accounting% 'here are potentiall! over -./ ad)ustments that could be made but in practice onl! five or seven
ke! ones are made, depending on the compan! and the industr! it competes in%
EVA 0alculation1
EVA 2 3et 4perating +rofit After 'axes 5 a 0apital 0harge 6the residual income method7
therefore EVA 2 34+A' - #c x 0apital$, or alternativel!
EVA 2 #r x 0apital$ 5 #c x 0apital$ so that
EVA 2 #r-c$ x 0apital 6the spread method, or excess return method7
(here1
o r 2 rate of return, and
o c 2 cost of capital, or the 8eighted Average 0ost of 0apital #8A00$%
34+A' is profits derived from a compan!"s operations after cash taxes but before financing costs and non-cash
bookkeeping entries% It is the total pool of profits available to provide a cash return to those (ho provide capital to
the firm%
0apital is the amount of cash invested in the business, net of depreciation% It can be calculated as the sum of
interest-bearing debt and euit! or as the sum of net assets less non-interest-bearing current liabilities #3I90:s$%
'he 0apital 0harge is the cash flo( reuired to compensate investors for the riskiness of the business given the
amount of economic capital invested%
'he cost of capital is the minimum rate of return on capital reuired to compensate investors #debt and euit!$ for
bearing risk, their opportunit! cost%
Another perspective on EVA can be gained b! looking at a firm"s ,eturn on 3et Assets #,43A$% ,43A is a ratio
that is calculated b! dividing a firm"s 34+A' b! the amount of capital it emplo!s #,43A 2 34+A';0apital$ after
making the necessar! ad)ustments of the data reported b! a conventional financial accounting s!stem%
EVA 2 #,43A 5 ,euired minimum return$ x 3et Investments
If ,43A is above the threshold rate, EVA is positive%
'able A 5 Economic +rofit 'ree% Evaluation of an enterprise looking at the margins and <"s%
Economic +rofit tree !ou can see !our strengths and limiters, !ou also see ho( -= value drivers are connected, ho(
the! have trended over time, and ho( each ranks vs% the industr! - all in an intuitive, visual snapshot% In >/
seconds, !ou can get an incredibl! good sense of !our business performance profile% ?ou can also use the
Economic +rofit tree to break do(n value drivers into their subcomponents, so !ou can identif! and focus on exactl!
the right trouble areas%
Comparison with other approaches
4ther approaches along similar lines include ,esidual Income #,I$ and ,esidual 0ash Flo(% Although EVA is
similar to ,esidual Income, under some definitions there ma! be minor technical differences bet(een EVA and ,I
#for example, ad)ustments that might be made to 34+A' before it is suitable for the formula belo($% ,esidual 0ash
Flo( is another, much older term for economic profit% In all three cases, mone! cost of capital refers to the amount
of mone! rather than the proportional cost #< cost of capital$@ at the same time, the ad)ustments to 34+A' are
uniue to EVA%
Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of
AprofitA, the utilit! of having a separate and more precisel! defined term such as EVA is that it makes a clear
separation from dubious accounting ad)ustments that have enabled businesses such as Enron to report profits (hile
actuall! approaching insolvenc!%
4ther measures of shareholder value include1
Added Value
Barket value added
'otal Shareholder ,eturn%
Relationship to Market Value Added
'he firm's market value added, or BVA, is the discounted sum
#present value$ of all future expected Economic Value
Added1 #'he image to the right sho(s the relationship (ith
BVA and EVA% BVA can be establisehed b! looking at the
Extra value placed on the enterprise over and above its Assets% In other (ords (hat the investors see as its added
Value% 'his should also represent the 3+V of all future EVA"s
Bore enlightening is that since BVA 2 3+V of Free cash flo( #F0F$ it follo(s therefore that the
3+V of F0F 2 +V of EVA@
since after all, EVA is simpl! the re-arrangement of the F0F
formula%
The ack!round to usin! EVA " MVA
'(o measures of financial performance that are being applied
increasingl! in investor-o(ned and not-for-profit healthcare
organiCations are market value added #BVA$ and economic
value added #EVA$%
Dnlike traditional profitabilit! measures, both BVA and EVA
measures take into account the cost of euit! capital% BVA is
most appropriate for investor-o(ned healthcare organiCations
and EVA is the best measure for not-for-profit organiCations%
As financial managers become more familiar (ith BVA and EVA
and understand their potential, these t(o measures ma! become
more (idel! accepted accounting tools for assessing the
financial performance of investor-o(ned and not-for-profit
organiCations%
Ban! recent articles have discussed the merits of t(o measures of financial performance, market value added
#BVA$ and economic value added #EVA$%#a$ 8ith all the attention being given to these measures, financial
managers should familiariCe themselves (ith the definitions, rationale, and potential uses of these measures%
9oth BVA and EVA are applicable to investor-o(ned organiCations@ ho(ever, EVA also is an appropriate measure
for not-for-profit organiCations% BVA assesses the effect of managerial actions on shareholder (ealth
from an organiCation's inception, (hile EVA assesses managerial effectiveness in a given !ear%
An important goal of an! investor-o(ned organiCation is to maximiCe shareholder (ealth%
And, although the fundamental goal of shareholder (ealth maximiCation is (idel!
accepted, financial managers must recogniCe that maximiCing shareholder (ealth is not the same
thing as maximiCing the organiCation's total market value% An organiCation's total market
value can be increased b! raising and investing as much capital as possible, (hich
increases the siCe of the organiCation and, therefore, often benefits managers% Eo(ever, this strateg! rarel! is in the
best interests of shareholders because it ignores the fact that shareholders have opportunit! costs, and must earn a
reasonable rate of return on their investments%
Student E#ercise$
As part of !our *roup Stud! !ou (ill be reuired to include at least one slide on an evaluation of BVA and EVA%