14.11 Economic value added as an alternative to SVA

Question 1

Stern Stewart and Co developed the concept of “Economic value added” (EVA). What is this?

Answer 1

A measure of profitability and wealth created for shareholders over and above the cost of invested capital.

Question 2

How is “Economic value added” (EVA) calculated?

Answer 2

EVA = [net operating profit after tax] - [weighted average cost of capital] x capital invested

Question 3

How is weighted average cost of capital (WACC) calculated?

Answer 3

WACC = [proportion of equtiy x cost of equity] + [proportion of debt x post-tax cost of debt]

Question 4

What are the strengths of economic value added (EVA) for calculated of shareholder value?

Answer 4

• uses simple and familiar accounting concepts (profit, cost of capital etc)
• considers both capital and operating costs
• very useful for mature, stable and asset-rich companies

Question 5

What are the weaknesses of economic value added (EVA) for calculated of shareholder value?

Answer 5

• restricted to short term projects as it does not account for future cash flows
• relies on accounting profit which can be subjective
• intangible assets such as brand and reputation are not considered