Term Paper on "EVA Economic Value Added (EVA)"

Term Paper 8 pages (2066 words) Sources: 7 Style: APA

[EXCERPT] . . . .

EVA

Economic value added (EVA) is a performance measure developed by Stern Stewart & Co to measure the true economic profit produced by a company. It is frequently also referred to as "economic profit," and can provide a measurement of a company's economic success over a period of time. Such a measure is valuable for investors who wish to know how well a company has performed over a period of time, and it is possible to take the results and compare them with other companies in the same category to determine how well the company compares.

It is a method devised to calculate the true economic profit of a corporation. EVA can be determined as net operating after taxes, profit minus a charge for the opportunity cost of the capital invested. The formula is set out below.

According to Stern Stewart & Co., EVA is a way of determining the probable amount that earnings will differ from the minimum rate of return needed, considering comparable risk, for shareholders and lenders. The difference can be a plus or a minus amount.

The basic formula for calculating EVA is:

Net Sales

Operating Expenses

Operating Profit (EBIT)

Taxes

Net Operating Profit After Tax (NOPAT)

Capital Charges (Invested Capital X Cost of Capital)

ECONOMIC VALUE ADDED (EVA)

For example, if a fictional firm, Cathy's Thingamajig Company (CTC), has 2005 net after-tax operating profits of $200,000 and invested capital of $2 million at an average cost of 8.5%, then CTC's economic profit would be computed as $200,000 - ($2 million x 8.5%) = $30,000. This $30,000 represents an amount equal to 1.5% of CTC's invested capital, providing a standardized measure for the wealth the company generated over and above its outlay of capital during the year.

By including all capital costs, including equity, EVA determines the amount of wealth a business has earned or lost during a certain reporting period. In other words, EVA is the actual profit. Shareholders expect a 10% return on their investment, they earn money only to the extent that their share of the net profit after tax exceeds 10% of equity capital. Anything before that adds up to the minimum acceptable compensation for investing in a risky enterprise.

EVA is an estimate of the amount by which earnings fall short or exceed the required minimum rate of return shareholders or lenders expect at comparable risk. Unlike market-based measures, such as Market Value Added (MVA), EVA can be calculated at divisional (Strategic Business Unit) levels. EVA is a flow, unlike stock measures, and can be used for performance evaluation over a certain period. Unlike accounting profit, such as Earnings Before Interest and Tax (EBIT), Net Income and Earnings per Share (EPS), EVA is economic. EVA is based on the concept of businesses having to cover both operating costs and capital costs.

EVA was developed to help managers to incorporate two basic principles of finance into their decision making, to align decisions with shareholder wealth. The primary financial objective of any company should be to maximize the wealth of its shareholders. The value of a company depends on the extent to which investors anticipate profits to differ from the cost of capital. A sustained increase in EVA results in an increase in the market value of a company. This approach has proven valid and effective for all types of organizations, and some of them are analyzed below. The level of EVA isn't what actually matters. If current performance is already reflected in share prices, it is the (continuous) improvement in EVA that earns continuous increases in shareholder wealth.

Some specific uses of EVA include:

To set organizational goals

Performance measurement

Determining of bonuses.

Communication with shareholders and investors

Motivation of managers

Capital budgeting

Corporate valuation

Analyzing equities

As a company performs well over time, it will retain earnings. This improves the book value of the company's shares, so investors will probably bid the prices up in expectation of future earnings, creating a rising market value. When this happens, the difference found between the company's market value and the capital contributed by investors (its MVA) represents the excess price tag the market assigns to the company as a result of it past operating successes.

An analyst, David Harper, Contributing Editor and Investopedia Advisor, concludes that from a commercial standpoint,

Economic Value Added (EVA) is the most successful performance metric that companies and their consultants can use. Though much of its popularity is a result of marketing and deployment by Stern Stewart, owner of the trademark, the success of the measurement tool is proven by financial theorists and it remains consistent with valuation principles, important to the valuation and analysis of a company.

This metric (also known as "economic profit") appears to be complex, but this is only an illusion. In fact it is based on three simple ideas: cash is king, some expenses are really investments, and equity capital is expensive.

When this measuring tool is used, it compares favorably with other performance metrics. It is easily calculable, has strengths and weaknesses, but is ideal for certain situations (though not for all).

Using EVA to justify IT investments, an editorial in Computer Economics analyzes how a CIO would write a business case that showed the executive management in terms of shareholder value. The EVA is said to be a powerful tool for calculating the business value of an IT investment. A fictitious company decides to propose an IT investment and the EVA improves. Hitherto, IS organizations did not use formal ROI calculations to justify investments because they did not ask for justification if it appeared that the CIO might possibly want to expend funds for this investment. After 1999, dot.com CIOs appeared to be bullet-proof when it came to expenditures while they were booming.

Secondly, it is not always clear what the relationship between an investment and its benefits are in this type of corporation. For example, if an executive orders a new software package on the basis that it will improve sales, it will not be clear whether the software package was actually the reason why the corporation's sales flourished, or whether it was one or more of the other techniques and factors that were used by the sales department that caused the increase. Isolating the various factors and their effect on sales is difficult to say the least.

In spite of the difficulties in determining the rationale of IT investments, senior executives are now asking IS leaders more pointed questions on how much a proposed technology investment will improve certain business and financial measurements.

In order to answer these questions, CIOs must be able to "think like the CEO."

So, to measure corporate performance, CIOs have been utilizing a relatively simple concept known as Economic Value Added (which is a registered trademark of Stern Stewart & Co.) in recent years.

The key concepts of Economic Value Added, or EVA, are shown below. EVA is calculated by taking net operating profit after tax (NOPAT) and subtracting the charge for the capital used to produce profits. EVA can be improved by generating more profits with the same capital (e.g. inventory, accounts receivable, cash, plants, equipment), or by producing the same level of profits using fewer capital. The power of EVA is that it focuses the attention of decision-makers on what will increase the company's value to shareholders: growing sales, reducing costs, and better managing assets.

This is a simple example of how EVA is calculated on a company-wide basis, along with any adjustments that need to be made in order to determine EVA and compare it with traditional financial statements.

Even if a company has not yet implemented EVA as a corporate performance measurement system, EVA can be used as a tool to evaluate technology investments.

To evaluate a specific investment, we only need to estimate the change in EVA that would result if management approves the capital investment. In this way we can make simple, safe assumptions about net profits and how the cost of capital affects them. As long as we are consistent in our assumptions, the impact of the proposed investment on EVA will tell us a lot about whether the investment decreases or increases shareholder value.

The example identifies benefits of any new system that would result in an improvement in NOPAT and the result in an improvement in asset turnover, or in reduced capital charge. In summary, it shows how to account for the system's initial investments as well as the ongoing operating costs of the system.

Without looking at an EVA analysis of investment, decision-makers may focus on the improvement in net profit rather than the considerable benefit to shareholders that comes with the improvement in asset turnover.

In real life the use of EVA justifies a large enterprise system to a corporate parent, and gives the reasons that improved asset turnover is the best way to improve EVA through new systems. Also, key metrics for improving EVA vary by industry are determined, including recommendations for technology… READ MORE

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