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Economic Value Added: A Detailed Walkthrough

Essay 2013 17 Pages

Business economics - Investment and Finance

Excerpt

TABLE OF CONTENTS

ABSTRACT

LIST OF ABBREVIATIONS

LIST OF FORMULAS

1. INTRODUCTION

2. EVA - THE ONE PROFIT FIGURE
2.1 CALCULATION OF ECONOMIC VALUE ADDED
2.2 THE BENEFITS AND DRAWBACKS OF EVA®
2.2.1 Benefits of applying EVA®
2.2.2 Pitfalls of applying EVA®

3. THE RELATIONSHIP BETWEEN ECONOMIC VALUE ADDED AND DISCOUNTED CASHFLOW MODEL

4. THE RELATIONSHIP BETWEEN ECONOMIC VALUE ADDED AND CASH CONVERSION CYCLE

5. CONCLUSION

6. REFERENCE LIST

LIST OF ABBREVIATIONS

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LIST OF FORMULAS

Formula 1 EVA® after tax

Formula 2 Capital Charges

Formula 3 Cost of Capital

Formula 4 Effect of depreciation on EVA®

Formula 5 Effect of depreciation on EVA®

Formula 6 Effect of depreciation on EVA®

Formula 7 Net Present Value

Formula 8 Free Cash Flow

Formula 9 NPV with EVA®

Formula 10 NPV with EVA®

Formula 11 NPV with EVA®

ABSTRACT

In the past, key financial instruments were focusing on concepts like the return on investment, return on equity and return on capital employed. However, within recent years, the flaws of the named ratios made it difficult to thoroughly rely on such figures any longer. As one key drawback connected to those solely finance-related ratios was that all non-financial aspects are missed out on. Further, the economic value creation was not respected in past models. EVA®, economic value added, is a concept on the rise that counteracts the flaws of recent financial ratios. By accounting for both the capital charges for investors and creditors, it allows a more sophisticated look into the value creation of a company. However Stern Steward & Co, who founded EVA®, give recommendations, so called adjustments, in order to make EVA® even more effective as it is without. As economic decision are not only covered by introducing a new ratio, it is important to contrast and to integrated EVA® to other frequently used financial models. Here, the net present value calculation is used most when evaluating on whether or not to take on a project. Now, the author shows that EVA® even can be used for net present value calculations, which is usually done by taking into consideration future cash flows. Further, economic profit is not all a modern business has to care about. In this respect, cash management has evolved in becoming a crucial cornerstone in financial management. Hence, the author has compared the cash conversion cycle to the EVA®. The questions is, does liquidity also affect the EVA® result? Finally, the author concludes on whether or not EVA® can be regarded as ‘the one financial ratio’ and how it interplays with other important models used in modern companies.

Economic Value Added Financial Ratios Liquidity Management Project Valuation

1. INTRODUCTION

For years, numerous adaptations to the return on investment (ROI) concepts, which focused on financial measures, entered the business world (Johnson, 1983). In detail, the most dominate traditional accounting-based measures in the 1900s where earnings per share (EPS) , return on equity (ROE) and the return on assets (ROA) (ArabSalehi & Mahmoodi, 2011). However, by the 1980s, a growing consensus built up, arguing that these traditional financial performance measurement systems were no longer sufficient in modern and competing markets. Due to the growing number of demanding customers, there was now a greater responsiveness and external focus for activities of the company. In fact, traditional performance measures focus on the results of an organisation, but fail on highlighting how performance is achieved and how it can be improved in the future (Kennerley & Neely, 2003). Hence, in the 20th century, the traditional measures continuously where pushed out of the business context. The main reasons where the critics of missing an indicator for risk experienced by owners and investors, the disregards of the time value of money and the fact accounting profit only respects interest rates and not the cost of equity (Baran, Hrotko & Olejník, 2007). Therefore, in 1993, the American consulting company ‘Stern Steward & Co’ developed a new criterion of evaluating the outcomes of companies. In detail, this refers to the economic value added (EVA®) and later also the market value added (MVA) performance measure. EVA, which is protected with a trade-mark, argues that “earnings, earnings per share and earnings growth are misleading measures of corporate performance and the best practical periodic performance measure is EVA ®” (Stewart, 1991, p.66). Since the 1990s, EVA® has been adopted by numerous important organisations such as AT&T, Coca Cola and Sprint. The unofficial number of companies working with EVA®, however, is higher as some company name it differently in order to not have to pay for the usage (Biddle et al., 1997, 1998). Here, the REWE group only calls it ‘Value Added’, still referring to the same economic value added measurement. However, is there really the one performance measure? There are still some critics that say, that even EVA® is not the ultimate tools but rather cash value added (CVA) following the notion of cash being a fact and profit being an opinion. Hence, the author will further asses the EVA® measurement and draw conclusions about possible relationships to NPV and CCC.

2. EVA - THE ONE PROFIT FIGURE

2.1 CALCULATION OF ECONOMIC VALUE ADDED

EVA® in essence can be defined as the difference between the net operating profit after taxes and the cost of invested capital. Here, multiple financial terms are used to describe the same calculation. In the following, the author will refer to NOPAT as being the net operating profit after tax and the capital charges being weighted average cost of capital (WACC) multiplied with the capital employed (CE). Hence, the formula of the EVA® after tax calculation can be stated as:

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The capital charges can be further broken down into:

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In order to ensure a common understanding of the calculation, the author further aims to break down WACC to enhance the level of detail on what influences the EVA® result in the end (Young & O'Byrne, 2000).

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When further defining the cost of equity, it is more than the simple ROE figure. In fact, cost of equity is put together by the risk-free return and an addition of a risk premium. In detail, the risk premium again is calculated by multiplying average market risk premium with systematic company risk premium. To explain the two named elements further, the average market risk premium compensates for the additional risk an investor is willing to take when investing into a share, compared to the risk-free rate. This is usually calculated by subtracting the risk-free rate from the return on stock investments. Looking at the systematic company risk premium, this describes the general variance between the return of a given company and the market return. In the finance world, this term is often also referred to as the beta- factor (Young & O'Byrne, 2000).

2.2 THE BENEFITS AND DRAWBACKS OF EVA®

2.2.1 Benefits of applying EVA®

As the author already has stated, through the history of the financial world,

profit figures continuously have developed and new measures were introduced. With EVA®, companies increasingly have noticed that traditional accounting profit measures did not fully respect the expectations of the owner, which, with the economic value added, is included. In fact, with having the WACC as one core component of the calculation, companies now not only take the cost of creditors into consideration, but also the required rate of return for the capital provided through the owners. On the people side, Stephens and Bartunek (1997) argued, that EVA® further aligns employee behaviour as to maximize wealth creation. This wealth creation is at the core of EVA® as managers are now not only incentivised by maximizing sales, but adding economic value. This makes it easy to align employee bonuses to the period EVA® of the company (Hopper, Northcott & Scapens, 2007). As EVA® is not incentivising short-term decision making, based on maximizing cash flows, it is assumed that introducing EVA® also enhances the perspective and the time horizon managers base decisions on (McLaren, 2005). Although another benefit of EVA®, which is often cited in the literature, is the simplicity of implementation, EVA® is considered to not be suitable for each and every company. Stewart (1995) themselves stated, that certain adjustments are required to successfully implement such a value creation measure in different organisations.

Summarizing the benefits of EVA®, it is worth mentioning the idea of the delta EVA®, where delta indicates change. Here, the EVA® result of the current year is compared to the EVA® figure of the past year, in relation to whether or not the current EVA® is positive or negative. To be more precise, the following matrix helps to illustrate that idea:

Figure 1

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Note: Sandt, J. (2010). Intermediate Management and Cost Accounting.

With that model, all stakeholders are now able to understand trends in the company without having to understand the numbers behind. If a company is coping with EVA® figures that are located in the area of value destroyer, all involved parties can understand this key term, which not only relies on ratios like ROA and ROE but can be seen as a very complex and detailed performance indicator. Here again, it is easy to highlight how EVA® performance can be linked to management incentives, stating in the employment contracts that benefits are only paid out when the delta EVA® is positive and therefore improves or even adds value to the company.

2.2.2 Pitfalls of applying EVA®

EVA® is usually calculated for one period, e.g. a year. In its raw format, EVA® allows for arbitrary profits. As the author has already mentioned, adjustments are required to account for flaws in the EVA® calculation. One of the most dominant issues connected with EVA® is the problem of depreciation. Without an extra adjustment, it is possible to push EVA® results simply by depreciating assets. In detail, when the net operating profit after tax of $50 million remains constant, and we assume that a given company employs assets worth $300 million and all of those assets are written down over three years with a WACC of 10% we see the following:

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Therefore, just by writing of assets, EVA® figures improve. For this reason, Fraport has started to calculate EVA® only with average capital employed figures to not allow the managers to only focus on short term strategies (Fraport, 2011). Another drawback that is frequently cited in the literature is the handling of the marketing and R&D costs. Without adjustments, these costs would be directly deducted from the earnings and capitalized as development costs that are then depreciated over a limited number of years. Further, a statutory reserve gets established equal to the depreciated amount. Now, with the adjustments, such costs are recorded as an asset and amortized over the expected economic timespan. The same is the case with deferred taxes, which are supposed to be deducted directly from the earnings.

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Details

Pages
17
Year
2013
ISBN (eBook)
9783656374831
ISBN (Book)
9783656376958
File size
565 KB
Language
English
Catalog Number
v209726
Institution / College
International University of Applied Sciences Bad Honnef - Bonn
Grade
2,0
Tags
EVA CVA Economic Value Added Cash Conversion Cycle Financial Ratios Ratios Cash Value Added ROE ROTA ROI

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Title: Economic Value Added: A Detailed Walkthrough