Term Paper on "Economic Value Added (EVA) an Examination"
Term Paper 7 pages (2228 words) Sources: 6
[EXCERPT] . . . .
Economic Value Added (EVA)An Examination of the Efficacy of Economic Value Can Improve a Company's Profitability
The need for improved transparency and improved corporate governance is greater than ever, and many companies are faced with increasing competition by virtue of a globalized marketplace. In this environment, some experts suggest that a company's economic value added function represents the best and most reliable method for measuring the profitability or value of the company and for maximizing shareholders' wealth today. Some analysts, though, have soundly criticized the economic value added technique as providing misleading results of financial performance. To determine the validity of these assertions, this study provides a discussion concerning how economic value added is in fact the most accurate tool for measuring profitability of a company and how various economic value added functions can be implemented to maximize the profitability of a company and therefore the organizational goal of maximizing shareholders wealth, followed by a summary of the research in the conclusion.
Review and Discussion
Background and Overview.
Economic value added (EVA) is shareholder value measurement technique that was originally developed by the New York firm of management consultants Stern Stewart Management Services (Mcmenamin, 1999). The original definition of EVA provided by Stern Stewart of New York City states that "EVA is the difference between a company's net operating income after taxes and its cost of capital of both equity and debt" (Stern Stewart, 1993, p. 37). Although the term EVA had appeared in t
download full paper ⤓
EVA = After tax operating income - (investment in assets x weighted average cost of capital). EVA is a dollar amount. If the dollar amount is positive, the company has earned more after-tax operating income than the cost of the assets employed to generate that income. In other words, the company has created wealth. If the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth. A company's goal is to have positive and increasing EVA. (Brewer et al., 1999, p. 4)
Because the EVA seeks to realistically measure a company's economic profit for a given year by making adjustments to the traditional accounting profit reported in the profit and loss account, profits, for example, will be adjusted to take into account any non-cash items such as depreciation; in this regard, yet another method of calculating EVA is as follows:
EVA = Operating profit cost of capital where,
Operating profit = Total revenues operating costs taxes
Cost of capital = Total capital supplied X cost of capital (Mcmenamin, 1999, p. 280).
In the formula above, the cost of capital is equal to the total value of all the capital supplied, debt and equity, multiplied by the weighted average cost of capital (WACC) (Mcmenamin, 1999). Further, the weighted average cost of capital is typically expressed as a single composite percentage figure that is determined by multiplying the cost of each individual source of capital -- ordinary shares, preference shares, bonds and loans, all valued at their market, not book, values -- by the respective proportion or percentage that each individual source forms of the total capital structure (Mcmenamin, 1999). According to this author, "The weighted average cost of capital (WACC) thus reflects the relative importance of each individual source of long-term finance in the firm's overall capital structure" (Mcmenamin, 1999, p. 280). Not surprisingly, not everyone is in agreement that the EVA approach provides managers with a meaningful and realistic picture of a company's financial performance during a given period of time, and these issues are discussed further below.
Efficacy of Economic Value Added as a Measure of Profitability.
According to Ray (2001), there is mixed evidence concerning the efficacy of economic value added as a financial-management tool. "In recent years," he advises, "Economic Value Added has been touted by the popular press as the financial savior of the corporate world. Indeed, Fortune magazine described EVA as 'today's hottest financial idea and getting hotter'" (p. 66). Financial-management initiatives such as identifying effective measures of a company's performance have been largely in response to a new emphasis on the financial aspects of organizational performance (Neely, 2002). While empirical observations suggest that value is what someone is willing to pay for something, the formal definition indicates that in this context, "Value is simply the quality/price which is perceived/paid by the customer. The quality component of value includes the inherent quality of the particular product or service, as well as all of its auxiliary features (follow-up service, complaint resolution, etc.)" (Ray, 2001, p. 66). If companies compete in free markets, then they are going to be faced with some tough decisions about what products and services they should provide their customers based on frequently changing wants and needs - and if they do not get it, they will quickly move on to a competitor that will. In this regard, Ray (2001) suggests that there must be a reasonable return on the customer's investment in terms of satisfaction for the price paid if there is any competition in a given industry. From the consumers' perspective, the price of the product or service must be on a par commensurate with, or, ideally commensurately lower than, the consumers' perceived value of the product or service received (Ray, 2001). Absent this, consumers will feel that they have not received real value from the transaction, and the bottom-line for the companies involved with be severe: "In the long run, if a firm's customers perceive that they're not receiving value, then the firm will almost certainly become just another corporate fatality (assuming free markets, of course)" (Ray, 2001, p. 66).
Many observers may suggest that the foregoing factors are intuitive and well-known in the business world, but Fletcher and Smith (2004) emphasize that the numerous financial metrics that are used otherwise to track financial performance may satisfy "spreadsheet junkies" by providing them with snippets of timely data, but these metrics fail to provide analysts with the "big picture" involved that takes into account all of the exchanges that are required to produce a company's return on shareholders' investment. For instance, Fletcher and Smith (2004) report that, "According to economic theory, a firm is creating value if the net present value of all its investments is positive. Quite simply, EVA is a measure that enables managers to see whether they are earning an appropriate return on the capital under their control. It is a measure of profit less the cost of capital employed and is the one measure that properly accounts for all the complex trade-offs, often between the income statement and balance sheet, in creating value" (Fletcher & Smith, 2004, p. 2). Even though the EVA represents a potentially valuable resource in the financial analysis toolbox, there are some constraints to its implementation and management that have caused some observers to suggest that it the approach is not all that it is cracked up to be, and these issues are discussed further below.
Implementing Economic Value Added Initiatives to Maximize Organizational Profitability.
The increasing popularity of the economic value added approach to measuring a company's financial performance has been accompanied by a number of scholarly studies that have determined that while the EVA formula itself might be straightforward, implementing these processes that support the approach are not as easy. For example, according to their recent study, "Managing for Value," Fletcher and Smith (2004) report that, "Economic value added (EVA) systems have generated a tremendous interest in corporate America recently as approaches to performance management. Implementation of these methodologies has not proven to be easy" (emphasis added) (p. 1). Likewise, Mcmenamin (1999) points out that, "The fact that new techniques or approaches to value measurement are continually being developed and promoted is testimony to the importance of the value concept in business and finance and also of the inherent complexity in its measurement" (p. 279). Given these inherent constraints on implementation and administration, it is not surprising that there have been some mixed results using the economic value added approach.
Based on the results of their comprehensive analysis of how EVA… READ MORE
Quoted Instructions for "Economic Value Added (EVA) an Examination" Assignment:
Topics: EVA is the best/most reliable method for measuring the profatibility or value of the company and for maximizing shareholders's wealth.
Following point should be covered:
1.Discuss how EVA is the most accurate tool for measuring profitability of a company.
2.Discuss how EVA can be implemented for measuring the profitability of a company and hence to achieve the goal of maximizing shareholders wealth.
Citations:
Cite reference sources can include information from books,magazines, journals, and online sources. Most of the reference sources should have a publication date no earlier than 2002. Alleast three sources shoild be articles from journals.
How to Reference "Economic Value Added (EVA) an Examination" Term Paper in a Bibliography
“Economic Value Added (EVA) an Examination.” A1-TermPaper.com, 2006, https://www.a1-termpaper.com/topics/essay/economic-value-added-eva/33786. Accessed 4 Oct 2024.
Related Term Papers:
Shareholder and Stakeholder Values Term Paper
Shareholder and Stakeholder Values
It makes sense for our modern world to have a foundation of a market-based economy because there are inherent conditions in the competitive market system that… read more
Term Paper 30 pages (8113 words) Sources: 1+ Topic: Business / Corporations / E-commerce
Performance Measurement for Small Sized Hotel a Balanced Scorecard Approach Research Proposal
Balanced Scorecard Method
Performance Measurement for Small-Sized Hotel: a Balanced Scorecard Approach
The balanced scorecard approach to the measurement of company performance is gaining popularity. This approach takes into account… read more
Research Proposal 45 pages (13021 words) Sources: 40 Style: Harvard Topic: Business / Corporations / E-commerce
Fashion and Appearance Central to the Construction Essay
FASHION and APPEARANCE CENTRAL to the CONSTRUCTION of SOCIAL IDENTITIES?
The objective of this work is to answer the question of how is fashion and appearance central to the construction… read more
Essay 4 pages (1246 words) Sources: 3 Style: Harvard Topic: Fashion / Designers / Beauty
Fri, Oct 4, 2024
If you don't see the paper you need, we will write it for you!
We can write a new, 100% unique paper!