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Study Pack 40 EVA MVAIn corporate Finance Economic Value Added or EVA, a registered trademark of Stern Stuart is an estimate of afirm's economic profit- being the value created in excess of the required return of the companys investors(being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financingthe companies capital. The idea is that value is created when the return on the firm's economic capital employed isgreater than the cost of that capital. This amount can be determined by making adjustments to GAAP orIFRS accounting. There are potentially over 160 adjustments that could be made but in practice only five or sevenkey ones are made, depending on the company and the industry it competes in.

EVA Calculation:

EVA = Net Operating Profit After Taxes a Capital Charge [the residual income method]

therefore EVA = NOPAT - (c x Capital), or alternatively

EVA = (r x Capital) (c x Capital) so that

EVA = (r-c) x Capital [the spread method, or excess return method]

where:o r = rate of return, and

o c = cost of capital, or the Weighted Average Cost of Capital (WACC).

NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cashbookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital tothe firm.

Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum ofinterest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).The Capital Charge is the cash flow required to compensate investors for the riskiness of the business given theamount of economic capital invested.

The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) forbearing risk, their opportunity cost.

Another perspective on EVA can be gained by looking at a firms Return on Net Assets (RONA). RONA is a ratiothat is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) aftermaking the necessary adjustments of the data reported by a conventional financial accounting system.

EVA = (RONA Required minimum return) x Net InvestmentsIf RONA is above the threshold rate, EVA is positive.

Table A Economic Profit Tree. Evaluation of an enterprise looking at the margins and %s.

Economic Profit tree you can see your strengths and limiters, you also see how 14 value drivers are connected, howthey have trended over time, and how each ranks vs. the industry - all in an intuitive, visual snapshot. In 30seconds, you can get an incredibly good sense of your business performance profile. You can also use theEconomic Profit tree to break down value drivers into their subcomponents, so you can identify and focus on exactlythe right trouble areas.

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Comparison with other approachesOther approaches along similar lines include Residual Income (RI) and Residual Cash Flow. Although EVA issimilar to Residual Income, under some definitions there may be minor technical differences between EVA and RI(for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual CashFlow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amountof money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT areunique to EVA.Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of"profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear

separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits whileactually approaching insolvency.Other measures of shareholder value include:

Added Value

Market value added

Total Shareholder Return.

Relationship to Market Value AddedThe firm's market value added, or MVA, is the discounted sum(present value) of all future expected Economic ValueAdded: (The image to the right shows the relationship withMVA and EVA. MVA can be establisehed by looking at the

Extra value placed on the enterprise over and above its Assets. In other words what the investors see as its addedValue. This should also represent the NPV of all future EVAs

More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that theNPV of FCF = PV of EVA;since after all, EVA is simply the re-arrangement of the FCFformula.The background to using EVA & MVATwo measures of financial performance that are being appliedincreasingly in investor-owned and not-for-profit healthcareorganizations are market value added (MVA) and economicvalue added (EVA).

Unlike traditional profitability measures, both MVA and EVAmeasures take into account the cost of equity capital. MVA ismost appropriate for investor-owned healthcare organizationsand EVA is the best measure for not-for-profit organizations.

As financial managers become more familiar with MVA and EVAand understand their potential, these two measures may becomemore widely accepted accounting tools for assessing thefinancial performance of investor-owned and not-for-profitorganizations.

Many recent articles have discussed the merits of two measures of financial performance, market value added(MVA) and economic value added (EVA).(a) With all the attention being given to these measures, financial

managers should familiarize themselves with the definitions, rationale, and potential uses of these measures.

Both MVA and EVA are applicable to investor-owned organizations; however, EVA also is an appropriate measurefor not-for-profit organizations. MVA assesses the effect of managerial actions on shareholder wealthfrom an organization's inception, while EVA assesses managerial effectiveness in a given year.

An important goal of any investor-owned organization is to maximize shareholder wealth.And, although the fundamental goal of shareholder wealth maximization is widelyaccepted, financial managers must recognize that maximizing shareholder wealth is not the samething as maximizing the organization's total market value. An organization's total marketvalue can be increased by raising and investing as much capital as possible, whichincreases the size of the organization and, therefore, often benefits managers. However, this strategy rarely is in thebest interests of shareholders because it ignores the fact that shareholders have opportunity costs, and must earn a

reasonable rate of return on their investments.

Student Exercise:

As part of your Group Study you will be required to include at least one slide on an evaluation of MVA and EVA.