Ecomonic Value Added (EVA)

Question 1

What is the definition of EVA?

Answer 1

A measure of performance, similar to residual income

However, adjustments are made to financial profits and capital to truly reflect the economic value generated by the company

It is a measure of performance which is directly linked to shareholder wealth

Question 2

What type of performance measure is EVA?

Answer 2

Profitability

Question 3

How is EVA calculated?

Answer 3

NOPAT less (adjusted value of capital employed x WACC)

Question 4

What is NOPAT?

Answer 4

Net operating profit after tax

Question 5

What is the decision rule for EVA?

Answer 5

A positive EVA is favourable

Since the organisation is providing a return greater than that required by the providers of finance

Question 6

How are interest payments accounted for?

Answer 6

In WACC, interest paid net of tax

i.e. interest x (1 - tax)

Question 7

What are the NOPAT deduct adjustments?

Answer 7

Deduct:
Economic depreciation
Decrease in provisions
Amortisation of advertising, R&D, employee training
Depreciation of operating lease assets
Tax paid plus tax relief on interest (interest x tax rate)

Question 8

How is tax relief on interest calculated?

Answer 8

Interest x tax rate

Question 9

What are the NOPAT add adjustments?

Answer 9

Add:
Accounting depreciation
Increase in provisions
Advertising, R&D and employee training costs
Non-cash expenses
Operating lease payments

Question 10

What are the advantages of using EVA?

Answer 10

+ Encourages making investments for the future

+ Consistent with NPV, if NPV increases EVA will increase.
NPV is a widely used by businesses so will aid communication

+ Measures value created by managers - so is a good performance measure

+ Maximisation of EVA will create real wealth for shareholders

+ Easy to understand

Question 11

What are the drawbacks of using EVA?

Answer 11

• The full version requires over 100 adjustments to the figures/information in the financial statements
• Cannot be compared against divisions or businesses as it gives an absolute figure
• Based on historical data, whereas shareholders are interested in future performance
• Many assumptions when calculating WACC, making the calculation difficult and potentially inaccurate

Question 12

What is WACC?

Answer 12

(Proportion of equity x cost of equity) + (proportion of debt x POST TAX cost of debt)

Where post-tax cost of date is interest x (1 - tax)

Question 13

What does the value of EVA show?

Answer 13

The business has created “$X” of value in the last year

If positive, the net operating profit after tax more than covers the cost of capital used by the business

Question 14

What is the main benefit to an EVA approach?

Answer 14

Links to the corporate objective of maximizing shareholder wealth

Question 15

Why is EVA a more direct link to shareholder wealth than ROCE?

Answer 15

ROCE is less cash-like and more tied to the accounting assumptions around producing a profit figure

Question 16

How does EVA encourage investment for the future?

Answer 16

E.g. R&D expenditure
Takes it out of the operating profit figures and treats it as capital expenditure

This prevents dysfunctional behavior from management such as manipulating the results

Common issue is the unadjusted capital employed figure which is given in the financial statements and used in ROCE