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Economic Value Added (EVA)

The Economic Value Added (EVA) is a measure of surplus value created on an investment. EVA = (Return on Capital – Cost of Capital) (Capital Invested in Project)

Things to Note about EVA

DCF Value and NPV

Value of Firm = Value of Assets in Place + Value of Future Growth

= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects

= ( I + NPVAssets in Place) +

where there are expected to be N projects yielding surplus value (or excess returns) in the future and I is the capital invested in assets in place (which might or might not be equal to the book value of these assets).

The Basics of NPV

NPVj = :

Life of the project is n years

Initial Investment =

Alternative Investment

NPVj =

=

NPV to EVA

Define ROC = EBIT (1-t) / Initial Investment:

The earnings before interest and taxes are assumed to measure true earnings on the project and should not be contaminated by capital charges (such as leases) or expenditures whose benefits accrue to future projects (such as R & D).

Assume that

The present value of depreciation covers the present value of capital invested, i.e, it is a return of capital.

DCF Valuation, NPV and EVA

Value of Firm = ( I + NPVAssets in Place) +

=

=

=

In other words,

Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in Place + Sum of PV of EVA from new projects

A Simple Illustration

Assume that you have a firm with

IA = 100 In each year 1-5, assume that

ROCA = 15% D I = 10 (Investments are at beginning of each year)

WACCA = 10% ROCNew Projects = 15%

WACC = 10%

Assume that all of these projects will have infinite lives.

After year 5, assume that

Firm Value using EVA Approach

Capital Invested in Assets in Place = $100

EVA from Assets in Place = (.15 – .10) (100)/.10 = $50

+ PV of EVA from New Investments in Year 1 = [(.15 – .10)(10)/.10] = $5

+ PV of EVA from New Investments in Year 2 = [(.15 – .10)(10)/.10]/1.12 = $4.55

+ PV of EVA from New Investments in Year 3 = [(.15 – .10)(10)/.10]/1.13 = $4.13

+ PV of EVA from New Investments in Year 4 = [(.15 – .10)(10)/.10]/1.14 = $3.76

+ PV of EVA from New Investments in Year 5 = [(.15 – .10)(10)/.10]/1.15 = $3.42

Value of Firm = $170.86

Firm Value using DCF Valuation

Firm Value using DCF Valuation

In Summary

In Practice: Some Measurement Issues

Year-by-year EVA Changes

Year-to-Year EVA Changes

Year-to-Year EVA Changes

When Increasing EVA on year-to-year basis may result in lower Firm Value

If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case, the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods.

Firm Value and EVA Tradeoffs over Time

Firm Value and EVA Tradeoffs over Time

EVA and Risk

When the increase in EVA is accompanied by an increase in the cost of capital, either because of higher operational risk or changes in financial leverage, the firm value may decrease even as EVA increases. For instance, in the example above, assume that the spread stays at 5% on all future projects but the cost of capital increases to 11% for these projects. The value of the firm will drop.

EVA with Changing Cost of Capital

FEVA with Changing Cost of Capital

Advantages of EVA

  1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory that argues that the value of the firm will increase if you take positive NPV projects.
  2. It avoids the problems associates with approaches that focus on percentage spreads – between ROE and Cost of Equity and ROC and Cost of Capital. These approaches may lead firms with high ROE and ROC to turn away good projects to avoid lowering their percentage spreads.
  3. It makes top managers responsible for a measure that they have more control over – the return on capital and the cost of capital are affected by their decisions – rather than one that they feel they cannot control as well – the market price per share.
  4. It is influenced by all of the decisions that managers have to make within a firm – the investment decisions and dividend decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing decision affects the cost of capital.

EVA and Market Value Added

Implications of Findings

When focusing on year-to-year EVA changes has least side effects

  1. Most or all of the assets of the firm are already in place; i.e, very little or none of the value of the firm is expected to come from future growth. This minimizes the risk that increases in current EVA come at the expense of future EVA
  2. The leverage is stable and the cost of capital cannot be altered easily by the investment decisions made by the firm. This minimizes the risk that the higher EVA is accompanied by an increase in the cost of capital
  3. The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their cost of capital. This minimizes the risk that the increase in EVA is less than what the market expected it to be, leading to a drop in the market price.

When focusing on year-to-year EVA changes can be dangerous

  1. High growth firms, where the bulk of the value can be attributed to future growth.
  2. Firms where neither the leverage not the risk profile of the firm is stable, and can be changed by actions taken by the firm.
  3. Firms where the current market value has imputed in it expectations of significant surplus value or excess return projects in the future.

Note that all of these problems can be avoided if we restate the objective as maximizing the present value of EVA over time. If we do so, however, some of the perceived advantages of EVA – its simplicity and observability – disappear.