Week 1 - Economic Value Add (EVA)

Question 1

EVA definition

Answer 1

Measures companies wealth creation each year.

Question 2

EVA Formula

Answer 2

NOPAT - (WACC x Capital Employed)

Question 3

Aligning EVA with shareholder interests

Answer 3

Primary company objective should be to maximise shareholder wealth

Current level of EVA isn’t what matters for this, but continuous improvement in EVA that brings on-going improvements in shareholder wealth

Question 4

Trade-offs with EVA

6

Answer 4

Biddle, Bowen & Wallace (1997): EVA does not beat earnings

McLaren (2016):
EVA does not work in all instances e.g. market crises. In failing credit markets firms respond by holding cash balances to facilitate their business, making EVA no longer an appropriate objective
- Case study of 3 firms in New Zealand found that EVA led to short term decisions created the problem of failing to deal with moral hazard which destroyed firm value, thus firms scaled back EVA.
- Implementation issues as management have good accounting knowledge but not EVA

Can drive short-term thinking, might discourage high-risk long-term investments with uncertain short-term returns

EVA as an absolute number brings advantages, but does make comparison of firms/divisions of different size challenging

Inapplicability to certain business e.g. tech startups or pharma

Ittner & Larcker (2001) highlight that EVA requires numerous accounting adjustments e.g. capitalising R&D which can make it subjective & resource-intensive

Question 5

EVA Benefits

4

Answer 5

Discourages investments that don’t cover capital costs ,’, better resource allocation e.g. General Electric used EVA to identify underperforming assets

Aligns with shareholder goals for maximimsing shareholder wealth

Uses finance, accounting & management concepts thus more holistic view of performance than accounting measures alone

By only investing in projects w returns higher than cost of capital, managers bonuses should increase thus aligning manager & shareholder goals

Question 6

How EVA should first be used

Answer 6

EVA projections and outcomes should initially
be used alongside existing measures, so that managers have time to understand the system and see how EVA tracks against the conventional numbers

Question 7

Bonus Bank in EVA

Answer 7

A portion of bonus earned in one period is held at risk of destruction of value in subsequent period

Accumulates over time, giving deferred payouts based on sustained EVA improvement

Question 8

McLaren findnigs on bonus banks

Answer 8

EVA has to be compatible with culture, or recruitmenet and staff retention would be a problem e.g. In NZ had to have upper and lower caps on bonuses for cultural reasons

Created short term decision making

Delayed payouts thus difficult to keep motivation