technical
economic value added
relevant to ACCA Qualification Papers P4 and P5
creating value
‘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.
It is argued that linking performance to profit breeds a short‑termist
boom–bust culture. For instance, a firm might adopt a cost minimisation
programme to increase profits and, to this end, make immediate
redundancies. This short-term decision would most likely trigger
problems in the medium to long-term for the business. This is one of
the concerns that EVA™ directly addresses, and the principal success
of EVA™ as a performance metric is the link with long-term wealth
maximisation and discount factor techniques. Studies have shown that
companies that adopt EVA™ as a performance measure outperformed
their peers by 8.5% annually, and for those companies operating in a
declining market this jumps to over 12% per annum.
The real benefits are realised when EVA™ is further linked to
management compensation packages. In this scenario it was found that
companies outperformed their peers by 57% over a five-year period
(Stern Stewart, 2005).
Stern Stewart argues that EVA™ is the financial performance measure
that comes closer than any other to capturing the true economic profit of
an organisation, and is the performance measure most directly linked to
the creation of shareholder wealth over time. EVA™ is an estimate of the
amount by which earnings exceed or fall short of the required minimum
rate of return that shareholders and debt holders could get by investing in
other securities of comparable risk. The formula is as follows:
EVA = net operating profit after tax - WACC x book value of
capital employed
40  student accountant  October 2007
Stern et al (ed 2001) suggest that ‘when fully implemented’ EVA™ will
be ‘the centerpiece of an integrated financial management system that
incorporates the full range of corporate financial decision making’. It is
argued that the following advantages can be gained from the adoption of
an EVA™-based approach to performance measurement:
profits are shown in the way shareholders count them
company decisions are aligned with shareholder wealth
a financial measure is used that line managers understand
the confusion of multiple goals is ended.
Profits, the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA™.
Under conventional accounting, most organisations appear profitable,
but many, in fact, are not creating value. A simple example would be
that of a firm deciding to invest $50m cash in a bank account. At an
interest rate of 5% per annum the firm would generate interest of $2.5m
each year. In this scenario, the firm will create additional profit, but it is
extremely unlikely that this will create any value.
Peter Drucker has suggested in a Harvard Business Review article,
that ‘until a business returns a profit that is greater than its cost of
capital, it operates at a loss’. This is in spite of the fact that it still pays
tax as if it had a genuine profit. Drucker observes that such organisations
return less to the economy than they consume in resources, and that
instead of ‘creating’ they are in fact destroying wealth. EVA™ explicitly
recognises that when managers employ capital they must pay for it in the
same way that they would pay other operating expenses.
By taking all capital costs into account, including the cost of equity,
EVA™ shows the amount of wealth a business has created or destroyed
in each reporting period. In other words, EVA™ represents profit the way
shareholders define it. If the shareholders expect, say, a 10% return on
their investment, they ‘gain’ only to the extent that their share of after-tax
operating profits exceeds 10% of equity capital.

Aligning decisions with shareholder wealth
Stern et al (2001) argue that the development of EVA™ coincides with
the increased ‘empowerment’ of managers as decision makers, and is a
tool to meet the potential agency issues that are created when ownership
and management are separated.
It is argued that EVA™ helps managers incorporate two basic
principles of finance into their decision making. The first is that the
primary financial objective of any company should be to maximise the
wealth of its shareholders. The second is that the value of a company
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
increase in EVA™ will precipitate an increase in the market value of
an organisation. They further suggest that the adoption of an EVA™
approach has proved effective in virtually all types of organisation,
from emerging growth companies to those organisations involved in
‘turnaround’ situations. They believe that the current level of EVA™ isn’t
what really matters since the current performance of an organisation is
already reflected in its share price. It is the continuous improvement in
EVA™ that brings continuous increases in shareholder wealth.
A financial measure that line managers understand
EVA™ has the advantage of being conceptually simple and easy to
explain to non-financial managers, since it starts with familiar operating
profits and simply deducts a charge for the capital invested either in the
company as a whole, or in a business unit, or even in a single plant,
office, or assembly line. In addition, EVA™ is closely analogous to the
concept of residual income (RI) which is both widely practised and well
established in literature as a measure of divisional performance.
By assessing a charge for using capital, EVA™ raises managerial
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
the trade‑offs between the two. This broader, more complete view of
technical
the economics of a business can have a profound influence on business
performance. Unlike net present value (NPV) calculations, EVA™ can
be used as an effective performance measure because of its ability to
measure results periodically. Proponents of EVA™ assert that its use
provides a superior measure of the year-to-year value that the business
creates. Moreover, because EVA™ measures performance in terms of
‘value’, it should be the cornerstone of any financial management system
used to set corporate strategy, or to evaluate potential capital investment
decisions, corporate acquisitions, or performance.
Ending the confusion of multiple goals
Most companies use a confusing array of measures to express financial
goals and objectives. Strategic plans are often based on growth in revenues
or market share. Companies may evaluate individual products or lines of
business on the basis of gross margins or cash flow. Business units may
be evaluated in terms of return on assets or against a budgeted profit
level. Finance departments usually analyse capital investments in terms of
NPV, but weigh prospective acquisitions against the likely contribution to
earnings growth. And bonuses for line managers and business unit heads
are typically negotiated annually and are invariably based on a profit plan.
The result of such varied standards, goals, and terminology is usually
incohesive planning, operating strategy, and decision making.
EVA™ eliminates this confusion by using a single financial measure
that links all decision making with a common focus, ie ‘How do we
improve EVA™’. EVA™ is the only financial management system that
provides a common language for employees across all operating and staff
functions. It allows all management decisions to be modelled, monitored,
communicated, and compensated in a single and consistent way –
always in terms of the value added to shareholder investment.
EVA™ ADJUSTMENTS
Typical adjustments that are required in EVA™ calculations include:
October 2007  student accountant  41
technical
Adjustment to net profit Adjustment to capital employed
Add net capitalised intangibles Add net book value of intangibles
Add goodwill written off and Add cumulative goodwill and
accounting depreciation (deduct cumulative depreciation previously
economic depreciation) written off
Add increases in provisions such Add provisions such those in respect
as those in respect of bad debts of bad debts and deferred tax
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
In assessing EVA™, one should recognise that it is an annual measure
of performance with a historic perspective. The use of EVA™ represents
an attempt to measure whether the management of an entity has used
available funds in order to ‘create’ or ‘destroy’ value.
Under accounting conventions, retained profits are arrived at only
after a significant number of expenses and non-cash adjustments have
been made. It is arguable, however, that these might be perceived as
being similar to investments.
Investments in intangibles, such as promotional activities, research
and development, and employee training and development, are written
off in the income statement under conventional accounting rules. Each of
these items could be regarded as constituting discretionary expenditure
by management. Thus, in the calculation of EVA™ they would be added
back to capital employed on the premise that such expenditures would
have otherwise been available to be paid as dividend, or to reduce the
level of debt finance employed. Likewise, the amount of expenditure on
such items would be added to or deducted from the net profit or loss for
the year.
In calculating EVA™, depreciation and amortisation during the
period are added back to the capital employed. This is because, when
the assets were acquired, the funds expended would otherwise have
been available to the organisation and could have been returned to
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
expended by the management.
The addition to net profit, of increases in provisions such as bad
debts and deferred taxation, emanates from recognition of the need
to apply prudence under conventional accounting practices. There is
the tendency to be over-prudent in the making of provisions which
could seriously undermine the use of reported profit as a measure of
performance. From a balance sheet perspective, such over-prudence
leads to an understatement of the true capital employed within a
business.
The existence of operating leases and other forms of off-balance
sheet financing can create distortions in measuring performance based
on an understated capital base. The addition of such debt instruments
42  student accountant  October 2007
to capital employed avoids any distortion to calculated EVA™ values
resulting from management decisions which have affected the capital
gearing of the organisation. Otherwise, an organisation could improve its
EVA™ simply by replacing its equity with such debt capital. One must
be mindful of the need to add back any interest charged during a period
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
financed by debt capital. In the absence of such an adjustment, interest
paid would have been deducted from profit and again deducted in the
Value Co (VC):
Summary income statements for the year:
2007 2006
$m $m
Revenue 608 520
Pre-tax accounting profit (Note 1) 134 108
Taxation (46) (37)
Profit after tax 88 71
Dividends (29) (24)
Retained earnings 59 47
Summary balance sheet for the year ending:
2007 2006
$m $m
Non-current assets 250 192
Net current assets 256 208
506 400
Financed by:
Shareholders’ funds 380 312
Medium and long-term bank loans 126 88
506 400
Note 1: After deduction of the economic depreciation of the company’s
non-current assets. This is also the depreciation used for tax purposes.
Other information is as follows:
1 Capital employed at the end of 2005 amounted to $350m.
2 VC had non-capitalised leases valued at $16m in each of the years
2005 to 2007. The leases are not subject to amortisation.
3 VC’s pre-tax cost of debt was estimated to be 9% in 2006 and 10%
in 2007.
4 VC’s cost of equity was estimated to be 15% in 2006 and 17% in
2007.
5 The target capital structure is 70% equity, 30% debt.
6 The rate of taxation is 30% in both 2006 and 2007.

‘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
2007. These amounts were equal to the depreciation used for tax
purposes and depreciation charged in the income statements.
8 Interest payable amounted to $6m in 2006 and $8m in 2007.
9 Other non-cash expenses amounted to $20m per year in both 2006
and 2007.
Solution
As discussed above, in order to compute EVA™, adjustments must
be made to the conventional, after-tax profit measures of $71m and
$88m shown in the example. Usually, an adjustment is made to convert
depreciation (calculated under conventional financial accounting) to
an estimate of economic depreciation, but in this example we know
that profits have already been calculated using economic depreciation.
Non-cash expenses are added back since the adjusted profit attempts to
approximate cash flow after taking account of economic depreciation. Net
interest is also added back because the returns required by the providers
of funds will be reflected in the cost of capital deduction. It is vital to note
that net interest is added back because interest will have been allowed as
an expense when determining the payment of taxation.
The capital employed used to calculate EVA™ should be based on
adjustments that seek to approximate book economic values at the start
of each period. In practice, this might necessitate several adjustments.
However, because there is insufficient information in this example, the
book value of shareholders’ funds, together with medium and long-term
loans at the end of 2005, is used as a starting point in determining the
economic capital employed at the beginning of 2006.
2007 2006
$m $m
Adjusted profit 113.6 (88 + 20 + (0.7 x 95.2 (71 + 20 + (0.7 x
8)) 6))
Capital employed 416 (400 + 16) 366 (350 + 16)
The weighted average cost of capital should be based on the target
capital structure. The calculation is as follows:
2006: (15% x 0.7) + (9% x 0.7 x 0.3) = 12.39%
2007: (17% x 0.7) + (10% x 0.7 x 0.3) = 14.00%
EVA 2006 = 95.2 - (366 x 0.1239) = $49.85m
EVA 2007 = 113.6 - (416 x 0.14) = $55.36m
Potential problems of EVA™
The calculation of EVA™ can be complicated when many adjustments
are required.
EVA™ is difficult to use for inter-firm and inter-divisional comparisons
because it is an absolute rather than a relative measure. Allowance
should be made for size when inter-company comparisons are made.
technical
Due to the calculation being a year-to-year performance metric, the
result could be manipulated by, for example, choosing short‑term,
early yield projects over longer-term, delayed income stream, higher
yield projects. Management could also select projects with low
initial set up costs, and therefore with a lower overall NPV, over
those with high initial investment costs, and therefore with a higher
NPV. Management might also limit its investment cash flows, such
as research and development or advertising costs, to the long-term
detriment of the business.
EVA™ is a short-run concept that deals only with the current reporting
period, whereas managerial performance measures should focus on
the future results anticipated as a consequence of present managerial
actions. In an ideal world, divisional performance should be evaluated
on the basis of economic income by estimating future cash flows
and discounting them to their present value. This calculation could
be made for a division at the beginning and end of a measurement
period. The difference between the beginning and ending values
would represent the estimate of economic income. However, the main
problem associated with the use of estimates of economic income to
evaluate performance is that it lacks precision and objectivity. Very
often, the person who is best placed to provide the cash flow estimates
is the individual whose performance is being ‘measured’. In such
circumstances, managers may be tempted to provide biased estimates.
The use of estimates of economic income to evaluate performance
is also inconsistent with the external financial information used by
financial analysts to evaluate an organisation as a whole.
Other value drivers are ignored which might be important despite not
being disclosed in the accounts.
The use of conventional depreciation methods means that there is no
guarantee that the measurement of EVA™ in the short-term will be
consistent with the measurement of EVA™ in the longer-term.
Economic depreciation is difficult to estimate and conflicts with
generally accepted accounting principles, which may hinder its
acceptance by financial managers.
REFERENCES
Drury C, Management and Cost Accounting (7th edition), Thompson
Learning, 2006.
Stern J, Bennett Stewart III G, Chew Jr D, and Stern Stewart, 2001,
The EVA Financial Management System, in Chew Jr D, The New
Corporate Finance: Where Theory Meets Practice (3rd ed, pp
132–146), McGraw Hill, New York, 2001.
Stern Stewart, 2005, The Comparative Stock Market Performance of
Stern Stewart Clients, www.sternstewart.com/evaabout/
eva_works.php
Stern Stewart, January 2005, EVAluation: Stern Stewart clients
create more wealth than peers, www.sternstewart.com/content/
evaluation/info/ClientPerformance.pdf
Shane Johnson is examiner for Paper P5 and Matt Bamber is an ACCA
tutor at Newport Business School
October 2007  student accountant  43