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technical

economic value added


relevant to ACCA Qualification Papers P4 and P5

creating value
‘Economic Value Added’ (EVA™) is a trademark of the Stern Stern et al (ed 2001) suggest that ‘when fully implemented’ EVA™ will
Stewart consulting organisation. Stern Stewart maintains that the be ‘the centerpiece of an integrated financial management system that
implementation of a complete EVA™-based financial management incorporates the full range of corporate financial decision making’. It is
and incentive compensation system gives managers both better argued that the following advantages can be gained from the adoption of
information and superior motivation to make decisions that will an EVA™-based approach to performance measurement:
create the greatest shareholder wealth in any publicly-owned or profits are shown in the way shareholders count them
private organisation. company decisions are aligned with shareholder wealth
It is argued that linking performance to profit breeds a short‑termist a financial measure is used that line managers understand
boom–bust culture. For instance, a firm might adopt a cost minimisation the confusion of multiple goals is ended.
programme to increase profits and, to this end, make immediate
redundancies. This short-term decision would most likely trigger Profits, the way shareholders count them
problems in the medium to long-term for the business. This is one of The capital charge is the most distinctive and important aspect of EVA™.
the concerns that EVA™ directly addresses, and the principal success Under conventional accounting, most organisations appear profitable,
of EVA™ as a performance metric is the link with long-term wealth but many, in fact, are not creating value. A simple example would be
maximisation and discount factor techniques. Studies have shown that that of a firm deciding to invest $50m cash in a bank account. At an
companies that adopt EVA™ as a performance measure outperformed interest rate of 5% per annum the firm would generate interest of $2.5m
their peers by 8.5% annually, and for those companies operating in a each year. In this scenario, the firm will create additional profit, but it is
declining market this jumps to over 12% per annum. extremely unlikely that this will create any value.
The real benefits are realised when EVA™ is further linked to Peter Drucker has suggested in a Harvard Business Review article,
management compensation packages. In this scenario it was found that that ‘until a business returns a profit that is greater than its cost of
companies outperformed their peers by 57% over a five-year period capital, it operates at a loss’. This is in spite of the fact that it still pays
(Stern Stewart, 2005). tax as if it had a genuine profit. Drucker observes that such organisations
Stern Stewart argues that EVA™ is the financial performance measure return less to the economy than they consume in resources, and that
that comes closer than any other to capturing the true economic profit of instead of ‘creating’ they are in fact destroying wealth. EVA™ explicitly
an organisation, and is the performance measure most directly linked to recognises that when managers employ capital they must pay for it in the
the creation of shareholder wealth over time. EVA™ is an estimate of the same way that they would pay other operating expenses.
amount by which earnings exceed or fall short of the required minimum By taking all capital costs into account, including the cost of equity,
rate of return that shareholders and debt holders could get by investing in EVA™ shows the amount of wealth a business has created or destroyed
other securities of comparable risk. The formula is as follows: in each reporting period. In other words, EVA™ represents profit the way
shareholders define it. If the shareholders expect, say, a 10% return on
EVA = net operating profit after tax - WACC x book value of their investment, they ‘gain’ only to the extent that their share of after-tax
capital employed operating profits exceeds 10% of equity capital.

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Aligning decisions with shareholder wealth the economics of a business can have a profound influence on business
Stern et al (2001) argue that the development of EVA™ coincides with performance. Unlike net present value (NPV) calculations, EVA™ can
the increased ‘empowerment’ of managers as decision makers, and is a be used as an effective performance measure because of its ability to
tool to meet the potential agency issues that are created when ownership measure results periodically. Proponents of EVA™ assert that its use
and management are separated. provides a superior measure of the year-to-year value that the business
It is argued that EVA™ helps managers incorporate two basic creates. Moreover, because EVA™ measures performance in terms of
principles of finance into their decision making. The first is that the ‘value’, it should be the cornerstone of any financial management system
primary financial objective of any company should be to maximise the used to set corporate strategy, or to evaluate potential capital investment
wealth of its shareholders. The second is that the value of a company decisions, corporate acquisitions, or performance.
depends on the extent to which investors expect future profits to exceed
or fall short of the cost of capital. Stern et al argue that a sustained Ending the confusion of multiple goals
increase in EVA™ will precipitate an increase in the market value of Most companies use a confusing array of measures to express financial
an organisation. They further suggest that the adoption of an EVA™ goals and objectives. Strategic plans are often based on growth in revenues
approach has proved effective in virtually all types of organisation, or market share. Companies may evaluate individual products or lines of
from emerging growth companies to those organisations involved in business on the basis of gross margins or cash flow. Business units may
‘turnaround’ situations. They believe that the current level of EVA™ isn’t be evaluated in terms of return on assets or against a budgeted profit
what really matters since the current performance of an organisation is level. Finance departments usually analyse capital investments in terms of
already reflected in its share price. It is the continuous improvement in NPV, but weigh prospective acquisitions against the likely contribution to
EVA™ that brings continuous increases in shareholder wealth. earnings growth. And bonuses for line managers and business unit heads
are typically negotiated annually and are invariably based on a profit plan.
A financial measure that line managers understand The result of such varied standards, goals, and terminology is usually
EVA™ has the advantage of being conceptually simple and easy to incohesive planning, operating strategy, and decision making.
explain to non-financial managers, since it starts with familiar operating EVA™ eliminates this confusion by using a single financial measure
profits and simply deducts a charge for the capital invested either in the that links all decision making with a common focus, ie ‘How do we
company as a whole, or in a business unit, or even in a single plant, improve EVA™’. EVA™ is the only financial management system that
office, or assembly line. In addition, EVA™ is closely analogous to the provides a common language for employees across all operating and staff
concept of residual income (RI) which is both widely practised and well functions. It allows all management decisions to be modelled, monitored,
established in literature as a measure of divisional performance. communicated, and compensated in a single and consistent way –
By assessing a charge for using capital, EVA™ raises managerial always in terms of the value added to shareholder investment.
awareness of the need for care in the management of the balance sheet
as well as the income statement, and helps them to properly assess EVA™ ADJUSTMENTS
the trade‑offs between the two. This broader, more complete view of Typical adjustments that are required in EVA™ calculations include:

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technical

Adjustment to net profit Adjustment to capital employed to capital employed avoids any distortion to calculated EVA™ values
Add net capitalised intangibles Add net book value of intangibles resulting from management decisions which have affected the capital
gearing of the organisation. Otherwise, an organisation could improve its
Add goodwill written off and Add cumulative goodwill and EVA™ simply by replacing its equity with such debt capital. One must
accounting depreciation (deduct cumulative depreciation previously be mindful of the need to add back any interest charged during a period
economic depreciation) written off to net profit; this is not only consistent with the adjustment to capital
employed, but also avoids the ‘double-counting’ of interest paid on assets
Add increases in provisions such Add provisions such those in respect financed by debt capital. In the absence of such an adjustment, interest
as those in respect of bad debts of bad debts and deferred tax paid would have been deducted from profit and again deducted in the
and deferred tax calculation of EVA™.

Add back interest on debt capital Add debt to net assets such that it EXAMPLE OF AN EVA™ CALCULATION
forms part of capital employed
Value Co (VC):
In assessing EVA™, one should recognise that it is an annual measure
of performance with a historic perspective. The use of EVA™ represents Summary income statements for the year:
an attempt to measure whether the management of an entity has used 2007 2006
available funds in order to ‘create’ or ‘destroy’ value. $m $m
Under accounting conventions, retained profits are arrived at only Revenue 608 520
after a significant number of expenses and non-cash adjustments have Pre-tax accounting profit (Note 1) 134 108
been made. It is arguable, however, that these might be perceived as Taxation (46) (37)
being similar to investments. Profit after tax 88 71
Investments in intangibles, such as promotional activities, research Dividends (29) (24)
and development, and employee training and development, are written Retained earnings 59 47
off in the income statement under conventional accounting rules. Each of
these items could be regarded as constituting discretionary expenditure Summary balance sheet for the year ending:
by management. Thus, in the calculation of EVA™ they would be added 2007 2006
back to capital employed on the premise that such expenditures would $m $m
have otherwise been available to be paid as dividend, or to reduce the Non-current assets 250 192
level of debt finance employed. Likewise, the amount of expenditure on Net current assets 256 208
such items would be added to or deducted from the net profit or loss for 506 400
the year.
In calculating EVA™, depreciation and amortisation during the Financed by:
period are added back to the capital employed. This is because, when Shareholders’ funds 380 312
the assets were acquired, the funds expended would otherwise have Medium and long-term bank loans 126 88
been available to the organisation and could have been returned to 506 400
shareholders. Under EVA™ principles, it is the historic cost of non-current
assets (less a charge for economic depreciation) which is deemed to
be the relevant figure, due to the fact that it represents the total funds Note 1: After deduction of the economic depreciation of the company’s
expended by the management. non-current assets. This is also the depreciation used for tax purposes.
The addition to net profit, of increases in provisions such as bad
debts and deferred taxation, emanates from recognition of the need Other information is as follows:
to apply prudence under conventional accounting practices. There is 1 Capital employed at the end of 2005 amounted to $350m.
the tendency to be over-prudent in the making of provisions which 2 VC had non-capitalised leases valued at $16m in each of the years
could seriously undermine the use of reported profit as a measure of 2005 to 2007. The leases are not subject to amortisation.
performance. From a balance sheet perspective, such over-prudence 3 VC’s pre-tax cost of debt was estimated to be 9% in 2006 and 10%
leads to an understatement of the true capital employed within a in 2007.
business. 4 VC’s cost of equity was estimated to be 15% in 2006 and 17% in
The existence of operating leases and other forms of off-balance 2007.
sheet financing can create distortions in measuring performance based 5 The target capital structure is 70% equity, 30% debt.
on an understated capital base. The addition of such debt instruments 6 The rate of taxation is 30% in both 2006 and 2007.

42  student accountant  October 2007


technical
‘Economic Value Added’ (EVA™) is a trademark of the Stern Stewart consulting organisation.
Stern Stewart maintains that the implementation of a complete EVA™-based financial
management and incentive compensation system gives managers both better information,
and superior motivation, to make decisions that will create the greatest shareholder wealth in
any publicly-owned or private organisation.

7 Economic depreciation amounted to $64m in 2006 and $72m in Due to the calculation being a year-to-year performance metric, the
2007. These amounts were equal to the depreciation used for tax result could be manipulated by, for example, choosing short‑term,
purposes and depreciation charged in the income statements. early yield projects over longer-term, delayed income stream, higher
8 Interest payable amounted to $6m in 2006 and $8m in 2007. yield projects. Management could also select projects with low
9 Other non-cash expenses amounted to $20m per year in both 2006 initial set up costs, and therefore with a lower overall NPV, over
and 2007. those with high initial investment costs, and therefore with a higher
NPV. Management might also limit its investment cash flows, such
Solution as research and development or advertising costs, to the long-term
As discussed above, in order to compute EVA™, adjustments must detriment of the business.
be made to the conventional, after-tax profit measures of $71m and EVA™ is a short-run concept that deals only with the current reporting
$88m shown in the example. Usually, an adjustment is made to convert period, whereas managerial performance measures should focus on
depreciation (calculated under conventional financial accounting) to the future results anticipated as a consequence of present managerial
an estimate of economic depreciation, but in this example we know actions. In an ideal world, divisional performance should be evaluated
that profits have already been calculated using economic depreciation. on the basis of economic income by estimating future cash flows
Non-cash expenses are added back since the adjusted profit attempts to and discounting them to their present value. This calculation could
approximate cash flow after taking account of economic depreciation. Net be made for a division at the beginning and end of a measurement
interest is also added back because the returns required by the providers period. The difference between the beginning and ending values
of funds will be reflected in the cost of capital deduction. It is vital to note would represent the estimate of economic income. However, the main
that net interest is added back because interest will have been allowed as problem associated with the use of estimates of economic income to
an expense when determining the payment of taxation. evaluate performance is that it lacks precision and objectivity. Very
The capital employed used to calculate EVA™ should be based on often, the person who is best placed to provide the cash flow estimates
adjustments that seek to approximate book economic values at the start is the individual whose performance is being ‘measured’. In such
of each period. In practice, this might necessitate several adjustments. circumstances, managers may be tempted to provide biased estimates.
However, because there is insufficient information in this example, the The use of estimates of economic income to evaluate performance
book value of shareholders’ funds, together with medium and long-term is also inconsistent with the external financial information used by
loans at the end of 2005, is used as a starting point in determining the financial analysts to evaluate an organisation as a whole.
economic capital employed at the beginning of 2006. Other value drivers are ignored which might be important despite not
being disclosed in the accounts.
2007 2006 The use of conventional depreciation methods means that there is no
$m $m guarantee that the measurement of EVA™ in the short-term will be
Adjusted profit 113.6 (88 + 20 + (0.7 x 95.2 (71 + 20 + (0.7 x consistent with the measurement of EVA™ in the longer-term.
8)) 6)) Economic depreciation is difficult to estimate and conflicts with
Capital employed 416 (400 + 16) 366 (350 + 16) generally accepted accounting principles, which may hinder its
acceptance by financial managers.
The weighted average cost of capital should be based on the target
capital structure. The calculation is as follows: REFERENCES
Drury C, Management and Cost Accounting (7th edition), Thompson
2006: (15% x 0.7) + (9% x 0.7 x 0.3) = 12.39% Learning, 2006.
2007: (17% x 0.7) + (10% x 0.7 x 0.3) = 14.00% Stern J, Bennett Stewart III G, Chew Jr D, and Stern Stewart, 2001,
The EVA Financial Management System, in Chew Jr D, The New
EVA 2006 = 95.2 - (366 x 0.1239) = $49.85m Corporate Finance: Where Theory Meets Practice (3rd ed, pp
EVA 2007 = 113.6 - (416 x 0.14) = $55.36m 132–146), McGraw Hill, New York, 2001.
Stern Stewart, 2005, The Comparative Stock Market Performance of
Potential problems of EVA™ Stern Stewart Clients, www.sternstewart.com/evaabout/
The calculation of EVA™ can be complicated when many adjustments eva_works.php
are required. Stern Stewart, January 2005, EVAluation: Stern Stewart clients
EVA™ is difficult to use for inter-firm and inter-divisional comparisons create more wealth than peers, www.sternstewart.com/content/
because it is an absolute rather than a relative measure. Allowance evaluation/info/ClientPerformance.pdf
should be made for size when inter-company comparisons are made.
Shane Johnson is examiner for Paper P5 and Matt Bamber is an ACCA
tutor at Newport Business School

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