Sum of discounted residual income (606 + 2,478 + 2,502) = $5,586. This is the same as the net present value calculated using the cash flow method above. The small difference of $2 is due to rounding.
Note 1: Straight-line depreciation has been used, so annual depreciation is $10,000/3.
Note 2:
The finance charge is 10% of the net book value of the assets of the project at the start of each year:
Year 1 Year 2 Year 3
Opening net book value 10,000 6,667 3,334
Less depreciation (note 1) (3,333) (3,333) (3,334)
Closing net book value 6,667 3,334 0
Finance charge 1,000 667 334
This relationship between residual income – and therefore EVA – and net present value is important.
Return on capital employed and return on investment
So what of those well-known, traditional profit-based measures, return on capital employed and return on investment? We normally use the former description when discussing organisations, and the latter when describing divisions of organisations. A commonly used version of these calculations is as follows:
Return on capital employed (ROCE) = profit BEFORE interest and tax x 100
shares + reserves + long-term liabilities
Return on investment (ROI) = controllable profit x 100
capital employed
In principle, using these measures to assess the performance of the managers of an organisation should not conflict with the goal of maximising shareholder value. However, the following problems may exist:
- Profit can be manipulated – for example, by changing accounting policies or using different judgments. As one commentator noted: ‘Profit is a matter of opinion, cash flow is a matter of fact.’
- Managers may take decisions that improve profits in the short term, but may harm the business in the long term – such as cutting back on staff training or research expenditure.
- Using ROI as a performance measure for a divisional manager may lead to ‘goal incongruence’, where a manager rejects a potential project that may generate a positive net present value, if the project would reduce the manager’s measured return on investment.
These three potential problems should not exist when using EVA because:
- the adjustments made to profits in calculating NOPAT are designed to remove such accounting manipulations
- the fact that long-term value-adding expenditure can be capitalised when calculating EVA should remove any incentive that managers may have to take such short-term views
- any project that will generate a positive net present value will also increase EVA .
Disadvantages of EVA
EVA suffers from several disadvantages, such as:
- the adjustments to profits and capital can become cumbersome, especially if performed every year
- estimating the WACC can be difficult. While many organisations use models such as the CAPM, this is not a universally accepted method of determining the cost of equity
- the calculation of WACC is based on market values of equity and debt, while the finance charge applies this WACC to adjusted book values of equity and debt – so there is some inconsistency
- EVA is an absolute measure, so it cannot be used to compare companies of different sizes, unlike return on investment.
In spite of these disadvantages, EVA as a performance measure does assess the value created by managers, so is a more appropriate tool for measuring the performance of commercial organisations than profit-based ones.
Written by a member of the APM examining team
References
- John D Martin and J William Petty, Value Based Management, Harvard Business School Press 2000.
- Shane Johnson and Matt Bamber, ‘Economic Value Added’, Student Accountant (2007), ACCA
- Erik Stern, EVA Has Potential to Boost Employees’ Motivation, www.SternStewart.com/ 2011/04/erik-stern-eva/