Posted: December 2nd, 2014

Advanced Managerial Accounting Report

Advanced Managerial Accounting Report

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state:

– differences between the articles
– similarities between the articles
– the main findings of each article

the articles11.2 What Is EVA, and How Can It Help Your Company? Economic value added (EVA) and market value added (MVA) arenot just performance metrics used to rank

companies for investors—they can be used to manage your company better.
by Paul A. Dierks, CPA; and Ajay Patel*
Economic Value Added, or EVA, is a measure of financial performance that combines the familiar concept of residual income with principles of modem corporate finance—

specifically, that all capital has a cost and that earning more than the cost of capital creates value for shareholders. EVA is after-tax net operating profit—NOPAT—

minus a capital charge. If a company’s return on capital exceeds its cost of capital, it is creating true value for the shareholder. Companies consistently generating

high EVAs are top performers that are valued highly by shareholders. Both EVA and MVA (Market Value Added) have been highly publicized in leading business magazines,

but the focus usually is on what EVA and MVA are and how they are used externally to rank companies. Little detail is given on how the numbers in an EVA calculation

actually are determined—which we propose to do here. Further, we demonstrate that these techniques have utility within a company in managing a company’s operations, in

guiding its strategy, and in providing incentives to its employees. Key components of EVA are NOPAT and the capital charge—the amount of capital times the cost of

capital. NOPAT is profits derived from a company’s operations after taxes but before financing costs and noncash-book-keeping entries. It is the total pool of profits

available to provide a cash return to those who provided capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be

calculated as the sum of interest-bearing debt and equity or as the sum of net assets less noninterest-bearing current liabilities.1 The capital charge is the cash

flow required to compensate investors for the riskiness of the business given the amount of capital invested. Reducing the amount of working capital or fixed assets

required to run the business while holding profits steady increases EVA. The cost of capital is the minimum rate of return on capital required to compensate debt and

equity investors for bearing risk, e.g., cut-off rate to create value. In formula form, EVA = (r – c*) x capital; where r = rate of return;and c* = cost of capital, or

the weighted average cost of capital
Then, EVA = (r x capital) (c* x capital); EVA = NOPAT c* x capital ; and EVA = operating profits – a capital charge
Another perspective on EVA can be gained by looking at a firm’s RONA—Return on Net Assets. For a firm, RONA is a ratio that is calculated by dividing its NOPAT by the

amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. A

convenient formulation of EVA is obtained by multiplying the total amount of net assets tied up by the spread between RONA and a threshold or minimum rate of return

such as the cost of capital. Thus:
EVA = net investments x (RONA – required minimum return) If RONA is above the threshold rate, EVA is positive.
Gains in shareholder wealth are driven by gains in EVA. The market price of a stock incorporates the current level of EVA and the expectation of future EVA. To

increase the stock price, management must increase the current level of EVA and change the market’s expectations of growth in future EVA. In summary, EVA is really

just another definition of earnings—sales less operating expenses—with one more item subtracted, a charge for the use of the capital involved. It is true economic

profit consisting of all costs including the cost of capital.
WHAT IS MARKET VALUE ADDED (MVA)? Market Value Added, or MVA, is a measure of the wealth a company has created for its investors. In effect, MVA shows the difference

between what investors put in and what they can take out. EVA is the fuel that fires up a company’s MVA. A company that has a positive EVA year after year will see its

MVA rise, while negative EVA year in and year out will drag down MVA as the market loses faith that the company will ever provide a decent return on invested capital.

MVA is a cumulative measure of corporate performance that looks at how much a company’s stock
* From P. A. Dierks and A. Patel, “What Is EVA, and How Can It Help Your Company? Management Accounting (November 1997): 52-58. Reprinted with permission conveyed

through Copyright Clearance Center, Inc.

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