Table of contents

1.1 The objective and motivation of the study *

1.2 The structure of the study *

1.3 Terminology *

1.4 Case-companies and applied conversions *

2 Economic Value Added and its characteristics *

2.1 The main theory behind EVA * 2.1.1 The background of EVA *

2.1.2 Market Value Added defined * 2.2 A review of EVA as performance measure and as a yardstick of wealth creation * 2.2.1 The discrepancy in accounting rate of return (ROI) and EVA *

2.2.2 Some evidence on the correlation between EVA and share prices *

2.2.3 Evidence on EVA in management bonus plans * 2.3 EVA as a performance measure in corporate world * 2.3.1 Implications of EVA in corporate control *

2.3.2 The main problems with EVA in measuring operating performance *

2.3.3 How to improve EVA *

2.3.4 EVA and allocation of capital *

2.3.5 EVA vs. traditional performance measures *

2.3.6 EVA vs. other Value-based measures * 3 EVA in Group-level controlling *

3.1 A rational definition of EVA in business unit management * 3.1.1 Capital, NOPAT and Rate of return *

3.1.2 Taxes in EVA-formula *

3.1.3 Average cost of capital *

3.1.4 The essence of defining the capital costs accurately * 3.2 EVA in Bonus systems * 3.2.1 Arguments for using EVA in bonus systems *

3.2.2 Characteristics of feasible EVA-based bonus system *

3.2.3 The impacts of EVA’s imperfections to bonus system *

3.2.4 Possible EVA-based bonus plans * 3.3 Implementing EVA control inside organization *

4 EVA in case-SBU *

5 Summary and conclusions *

6 Literature references: *

Investors are currently demanding Shareholder value more strongly than ever. In the1980s, shareholder activism reached unforeseen levels with the companies in the United States (Bacidore et al. 1997). Thereafter also investors in Europe have increased the pressure on companies to maximize shareholder value. Even in Finland the so-called Shareholder value –approach has gained grounds. This is due to e.g. abolishing the restrictions on foreign stock ownership. Foreign investors emphasize and demand focus on Shareholder value -issues. (Lyttyniemi 1996)

The financial theory has since long suggested that every company’s ultimate aim is to maximize the wealth of its shareholders. That should be natural since shareholders own the company and as rational investors expect good long-term yield on their investment. In the past, this ultimate aim has however been often partly ignored or at least misunderstood. This can be seen e.g. from measurement systems. Metrics like Return on investment and Earnings per share are used as the most important performance measures and even as a bonus base in a large number of companies, although they do not theoretically correlate with the Shareholder value creation very well. Against this background it is no wonder that so-called Value based measures have received a lot of attention in the recent years. These new performance metrics seek to measure the periodic performance in terms of change in value. Maximizing value means the same as maximizing long-term yield on shareholders’ investment.

Currently the most popular Value based measure is Economic Value Added, EVA. There has been a vivid debate for and against EVA in academic and management literature. Unfortunately most EVA advocates and adapters have not acknowledged or discussed the faults of EVA, while they have praised the concept as a management tool. On the other hand most criticism against EVA has kept to fairly insignificant topics from the viewpoint of corporate control. There are currently very few articles dealing objectively with EVA’s strengths and weaknesses as a management tool.

This study seeks to clarify the concept of EVA especially from the viewpoint of business unit controlling. The objective of the study is twofold. Firstly, the study describes the theory and characteristics of EVA. This gives the framework to discuss the main objective: How companies should use EVA considering both its favorable and unfavorable features? In this context, the study also offers some recommendations of how EVA should be used as a management tool. The study tries to bring together the relevant theoretical issues and controlling practice. The topics discussed are essential and current in the case-group as well as in many other companies implementing EVA-approach in their organizations.

The study consists of three main chapters. The first discusses the general theory behind EVA. This chapter presents the background and basic theory of EVA as well as main findings about EVA in financial literature. The chapter explains also in general what EVA has to give to corporate world. The second chapter focuses on the use of EVA in group-level controlling. It discusses how EVA could be defined in controlling and reporting, how it can be used in bonus systems and what are the problems faced in implementing EVA. The third and final main chapter deals with EVA more practically inside the case SBU. The chapter presents with numerical example the calculation of EVA and the impacts of a few different calculation methods. Chapter also illustrates one possible way to allocate the capital costs in the case SBU.

Shareholder value = Shareholder value is being used as a overall term covering various aspects in thinking that promotes the interests of shareholders. Normally the term also means a company’s value to its shareholders i.e. market capitalization.

Shareholder value approach = Shareholder value approach refers to the focus of organization and management on acting within the interests of shareholders. Hence it means focus on maximizing the wealth of shareholders (creating shareholder value).

Value based measures = Value based measures are new performance measures that originate from the shareholder value approach. They seek to measure the periodic performance in terms of shareholder value created (or destroyed).

The subject will be discussed from both the viewpoint of the case-group and the case-SBU (Strategic business unit). The case-SBU is a unit of the case-group. From the reader’s point of view it is completely irrelevant which real companies this study deals with. Therefore the group and the parent company will be called Group A or (parent) Company A. The Group and the parent company have the same name also in reality. The SBU (daughter company) will be called Company B or SBU B. Company B has been a kind of EVA-pilot in the case-group, since it has used EVA in reporting and bonus systems from the beginning of this year (1997). This naturally influences the whole study. Some problems are discussed in the light of these early experiences.

All of the figures in this study have been conversed linearly, so that meaning of the figures and the respective relations between the figures are still unchanged even though they do not relate to any real numbers.

This chapter presents the main theory about EVA and shows some empirical findings around the concept in financial literature. The last section 2.3 tries to present what the theory of EVA means in practice for companies.

1. The main theory behind EVA

EVA measures whether the operating profit is enough compared to the total costs of capital employed. Stewart defined EVA (1990, p.137) as Net operating profit after taxes (NOPAT) subtracted with a capital charge:

EVA = NOPAT – CAPITAL COST

EVA = NOPAT – COST OF CAPITAL x CAPITAL employed (1)

Or equivalently, if rate or return is defined as NOPAT/CAPITAL, this turns into a perhaps more revealing formula:

EVA = (RATE OF RETURN – COST OF CAPITAL) x CAPITAL (2)

Where:

1. Rate of return = Nopat/Capital
2. Capital = Total balance sheet minus non-interest bearing debt in the beginning of the year

3. Cost of capital = Cost of Equity x Proportion of equity from capital + Cost of debt x Proportion of debt from capital x (1-tax rate). Cost of capital or Weighted average cost of capital (WACC) is the average cost of both equity capital and interest bearing debt. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. This derivation of equity cost and WACC is explained later in detail with chapter 4.2 (Company B’s EVA).

If ROI is defined as above (after taxes) then EVA can be presented with familiar terms to be:

EVA = (ROI – WACC) x CAPITAL EMPLOYED (3)

The idea behind EVA is that shareholders must earn a return that compensates the risk taken. In other words equity capital has to earn at least same return as similarly risky investments at equity markets. If that is not the case, then there is no real profit made and actually the company operates at a loss from the viewpoint of shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement because the shareholders have earned a return that compensates the risk. This approach — using average risk-adjusted market return as a minimum requirement — is justified since that average return is easily obtained from diversified long-term investments on stock markets. Average long-term stock market return reflects the average return that the public companies generate from their operations.

EVA is based on the common accounting based items like interest bearing debt, equity capital and net operating profit. It differs from the traditional measures mainly by including the cost of equity. Mathematically EVA gives exactly the same results in valuations as Discounted cash flow (DCF) or Net present value (NPV) (Stewart 1990, p.3 and Kppi 1996), which are long since widely acknowledged as theoretically best analysis tools from the Shareholders perspective (Brealey & Mayers 1991 p.73-75). These both measures include the opportunity cost of equity, they take into account the time value of money and they do not suffer from any kind of accounting distortions. However, NPV and DCF do not suit in performance evaluation because they are based exclusively on cash flows. EVA in turn suits particularly well in performance measuring. Yet, it should be emphasized that the equivalence with EVA and NPV/DCF holds only in special circumstances (in valuations) and thus this equivalence does not have anything to do with performance measurement. This peculiar characteristic of EVA is explained later in detail.

EVA is not a new discovery. An accounting performance measure called residual income is defined to be operating profit subtracted with capital charge. EVA is thus one variation of residual income with adjustments to how one calculates income and capital. According to Wallace (1997, p.1) one of the earliest to mention the residual income concept was Alfred Marshall in 1890. Marshall defined economic profit as total net gains less the interest on invested capital at the current rate. According to Dodd & Chen (1996, p.27) the idea of residual income appeared first in accounting theory literature early in this century by e.g. Church in 1917 and by Scovell in 1924 and appeared in management accounting literature in the 1960s. Also Finnish academics and financial press discussed the concept as early as in the 1970s. It was defined as a good way to complement ROI-control (Virtanen 1975, p.111). Knowing this background many academics have been wondering about the big publicity and praise that has surrounded EVA in the recent years. The EVA-concept is often called Economic Profit (EP) in order to avoid problems caused by the trademarking. On the other hand the name EVA is so popular and well known that often all residual income concepts are often called EVA although they do not include even the main elements defined by Stern Stewart & Co. For example, hardly any of those Finnish companies that have adopted EVA calculate rate of return based on the beginning capital as Stewart has defined it, because average capital is in practice a better estimate of the capital employed. So they do not actually use EVA but other residual income measure. This insignificance detail is ignored later on in order to avoid more serious misconceptions. It is justified to say that the EVA concept Finnish companies are using corresponds virtually the EVA defined by Stern Stewart & Co.

In the 1970s or earlier residual income did not got wide publicity and it did not end up to be the prime performance measure in great deal of companies. However EVA, practically the same concept with a different name, has done it in the recent years. Furthermore the spreading of EVA and other residual income measures does not look to be on a weakening trend. On the contrary the number of companies adopting EVA is increasing rapidly (Nuelle 1996, p.39, Wallace 1997, p.24 and Economist 1997/2). We can only guess why residual income did never gain a popularity of this scale. One of the possible reasons is that Economic value added (EVA) was marketed with a concept of Market value added (MVA) and it did offer a theoretically sound link to market valuations. In the times when investors demand focus on Shareholder value issues this was a good bite. Perhaps also pertinent marketing by Stern Stewart & Co. had and has its contribution.

EVA is aimed to be a measure that tells what have happened to the wealth of shareholders. According to this theory, earning a return greater than the cost of capital increases value (of a company), and earning less decreased value. For listed companies Stewart defined another measure that assesses if the company has created shareholder value. If the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. If the case is opposite, the market value is less than capital invested, the company has destroyed shareholder value. Stewart (1990,153) calls that difference between the company’s market and book value as Market Value Added or MVA for short.

MarkeT Value Added =

company’s total Market Value — capital invested

and with simplifying assumption that market and book value of debt are equal, this is the same as:

MarkeT Value Added =

Market Value of Equity — Book Value of Equity (3)

Book value of equity refers to all equity equivalent items like reserves, retained earnings and provisions. In other words, in this context, all the items that are not debt (interest bearing or non-interest bearing) are classified as equity.

Market value added is identical by meaning with the market-to-book -ratio. The difference is only that MVA is an absolute measure and market-to-book -ratio is a relative measure. If MVA is positive that means that market-to-book -ratio is more than one. Negative MVA means market-to-book -ratio less than one.

According to Stewart Market value added tells us how much value company has added to, or subtracted from, its shareholders’ investment. Successful companies add their MVA and thus increase the value of capital invested in the company. Unsuccessful companies decrease the value of the capital originally invested in the company. Whether a company succeeds in creating MVA (increasing shareholder value) or not, depends on its rate of return. If a company’s rate of return exceeds its cost of capital, the company will sell on the stock markets with premium compared to the original capital (has positive MVA). On the other hand, companies that have rate of return smaller than their cost of capital sell with discount compared to the original capital invested in company. Whether a company has positive or negative MVA depends on the level of rate of return compared to the cost of capital. All this applies also to EVA. Thus positive EVA means also positive MVA and vice versa. Stewart (p. 153) defined in his book the connection between EVA and MVA.

MarkeT Value Added = Present value of all future eva (4)

Market value added is equal to present value of all future EVA. Increasing EVA a company increases its market value added, or in other words increases the difference between company’s value and the amount of capital invested in it.

The relationship with EVA and MVA has its implications on valuation. By arranging the formulas above we find a new definition of the value of company:

Market Value of Equity =

Book Value of Equity + Present value of all future eva (5)

Following figure will illustrate this relationship between EVA and MVA:

Figure 1 Company’s market value depends directly on its future EVA.

The phenomenon with rate of return and MVA is in one sense similar to the relationship between the yield and market value of a bond. If the yield of a bond exceeds the current market interest rate (cost of capital) then the bond will sell at a premium (there is positive EVA and so the bond will sell at positive MVA). If the yield of a bond is lower than the current market interest rate then the bond will sell at discount (there is negative EVA and so the bond will sell at negative MVA).

If the net assets or capital in the EVA formula (formula 2) reflected the current value of a company’s assets and if the rate of return reflected the true return, then there would not be much questioning about the theory between EVA and MVA. After all, nobody questions the above connection between the market value, face value, interest rate and yield of a bond (obviously not since it hold almost perfectly also in practise). But with MVA and EVA things are little bit more complicated. The term capital in formula 2 does not reflect the current value of assets, because the capital is based on historical values. Nor does the rate of return reflect the true return of the company. All accounting based rate of returns (ROI, RONA, ROCE, ROIC) fail to assess the true or economic return of a firm, because they are based on the historical asset values, which in turn are distorted by inflation and other factors (Villiers 1997, p.287). Stewart defines his rate of return as return on beginning capital and as return after taxes but these adjustments do not affect the problems attached to accounting rate of return. The shortcomings of accounting rate of returns and the current research on the subject are presented in detail in next section (2.2.1.).

The valuation formula of EVA (formula 5) however is always equivalent to Discounted cash flow and Net present value, if EVA is calculated as Stewart presents. Thus the above valuation formula (formula 5) gives always the right estimate of value (same as DCF and NPV) no matter what the original book value of equity is. This holds true even though capital is not an unbiased estimate of current value of assets and rate of return is not an unbiased estimate of the true return. That is because an increase in book value (formula 5) decreases the periodic EVA-figures (and of course a decrease in book value increases EVA-fig.) and these changes cancel each other out. Also this phenomena will be discussed more in next section (2.2.1).

Every project that a firm undertakes should have positive Net present value (NPV) in order to be acceptable from the shareholders point of view. This means that a project should have internal rate of return bigger than the cost of capital. With practical performance measuring the internal rate of return can not be measured and some accounting rate of return is used instead to estimate the rate of return to capital. Typically this rate of return is some form of return on investment (ROI). Unfortunately any accounting rate of return can not on average produce an accurate estimate of the underlying true rate of return. Following example illustrates this problem, which is more thoroughly and with stronger theoretic background discussed below. The example presents an investment project with initial investment of 1200, duration of 8 years, constant gross profit of 210, IRR of 11% and with no salvage value.

Table A: Example how ROI estimates (both in different years and on average) the return of an investment producing a IRR of 11%.