EVA and Residual Income Flashcards
Economic Value Added (EVA(R)) is a relatively new metric, while residual income (RI) has been around for many years. The division manager, Jim Cole, has heard that residual income is helpful in preventing the diluted hurdle rate problem but does not know what the diluted hurdle rate problem is or how EVA(R) and RI differ.
In an effort to help Jim understand the issues involved, write a memo to Jim that explains how EVA(R) is both similar to and different from residual income.
Economic value added is a specific form of residual income. Economic value added defines the elements of residual income more precisely.
Economic Value Added (EVA(R)) is a relatively new metric, while residual income (RI) has been around for many years. The division manager, Jim Cole, has heard that residual income is helpful in preventing the diluted hurdle rate problem but does not know what the diluted hurdle rate problem is or how EVA(R) and RI differ.
Explain the diluted hurdle rate problem by using an example, and explain how using EVA (R) or RI solves the problem.
A manager with incentive compensation based on return on investment has four assets with an average return of 28%. The manager has idle cash to invest in a project that is expected to achieve a return of 25%. The company has a hurdle rate (which can be defined as the required minimum return target) of 20%.
Given these circumstances, the manager will be unwilling to invest in a project earning any amount less than the current 28% because it would dilute or reduce the current average return on the total.
This conclusion is bad for the company since the cash will remain unused. Since both residual income and economic value added are expressed in dollars, any increase in income from an acceptable investment will increase the manager’s potential compensation.
Therefore, comparison between investments is not influenced by returns previously earned on prior investments.
Define EVA(R).
Economic value added is defined as net operating profit after taxes, less the weighted average cost of capital multiplied by total assets minus current liabilities.
Define RI.
Residual income is defined as income less required return on investment multiplied by the investment base.
