Eva -Economic Value Added

10189 WordsDec 17, 201241 Pages
9-206-016 REV: JULY 11, 2006 MIHIR A. DESAI FABRIZIO FERRI Understanding Economic Value Added EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources . . . it does not create wealth; it destroys it.1 — Peter Drucker This note explores the concept of Economic Value Added (EVA)2 and its practical applications as a management control system for performance measurement and incentive compensation. The…show more content…
In short, the firm has paid its operating and capital costs and created additional wealth. Negative EVA, instead, suggests that the firm “devours resources” (in Peter Drucker’s terms) without providing a commensurate return for their use. The key feature of EVA is that it incorporates a charge for the use of both debt and equity capital. Accounting earnings, on the contrary, only deduct the (after-tax) cost of debt capital (i.e., the interest expense subtracted in the computation of net income). This difference has important implications in terms of motivating managerial behavior. Firms focused on earnings growth will end up investing in any project yielding a return greater than the (after-tax) cost of debt, rather than investing only in projects with returns greater than the overall cost of capital—the basic rule of Net Present Value (NPV) analysis. By explicitly identifying and incorporating the cost of equity capital, EVA raises the bar and makes managers more cognizant of the costs of the capital employed, thereby promoting more efficient allocation of capital. Other available measures also reflect the use of capital. Return on net assets (RONA), for example, is an indication of the ability to generate operating profits relative to the amount of capital employed. However, a simple algebraic manipulation will help explain the advantage of EVA over RONA. EVA = NOPAT − (Cost of Capital * Capital ) EVA =
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