Economic Value Added Essay Research Paper EVA

Economic Value Added Essay, Research Paper

EVA is a way of measuring a firm’s profitability. EVA is NOPAT minus a charge for all capital invested in the business (Byrne 1). A more intuitive way to think of EVA is as the difference between a firms NOPAT and its total cost of capital (Kramer & Pushner 40). Stern Staurt’s numerical definition of EVA is calculated for any year by multiplying a firm’s economic book value of capital at the beginning of the year by the spread between its return on capital and its cost of capital (K): EVA=(Rt-Kt)*Ct-1 (Kramer &Pushner 41). EVA is a notion of residual income (Ehrbar Xi). Investors demand a rate of return proportional to the amount of risk incurred. Operating profits determine residual income by plotting them against the required rate of return, a product of both debt and equity. EVA takes into account all capital invested. Peter Druker says in his Harvard Business Review article, “EVA is based on something we have known for a long time: What we call profits, the money left to service equity, is not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources .Until then it does not create wealth but destroys it” (Ehrbar 2). EVA is a measure of wealth creation or destruction after all costs are capitalized.

Companies use EVA as a measure of corporate performance, as an incentive system and as a link between shareholder and management/employee goals. Stock price indicates investor’s certainty concerning current and future earnings potential. EVA is a static measure of corporate performance; MVA is a dynamic, forward looking market performance measure. “MVA is a market generated number calculated by subtracting the Capital invested in a firm from the sum (V) of the total market value of the firm’s equity and book value of debt: MVA=Vt-Ct” (Kramer & Pushner 42). Al Ehrbar describes MVA as exactly equivalent to the stock market’s estimate of the NPV of a company. In 1998 CSX Corperation introduced EVA criteria to the fast growing but low margin CSX Intermodal business, where trains deliver freight to waiting trucks or cargo ships. Large amounts of capital are required to power a mammoth fleet of locomotive, containers and railcars. Figuring in capital costs, CSX Intermodal lost $70 million in 1988. “The CEO issued an ultimatum, et EVA up or be sold” (Fortune, 39). CSX Intermodal freight volume increased by 25%, yet they dramatically reduced their capital cost by reducing the number of container and trailers by 22%, reducing their locomotive fleet by 33%, and reducing fuel costs. EVA in 1992 was $10 million dollars, and was expected to triple the following year. Wall Street responded: CSX stock price rose from $28 before EVA to a 1993 price of $75. CSX concluded that investors care more about their net cash return on capital than accounting figures such as EPS, ROE and ROA.

Companies that adopt EVA as a performance measure found tie-in compensation plans very useful in aligning management behavior and shareholder needs. Typical plans consist of two familiar parts, a bonus and stock incentives, applied in new ways (Fortune 50). Bonus targets are established by a percent increase in EVA and recalculated each year by averaging the prior year’s goal and the prior year’s result. Bonus have no limits, but the manager incurs operating risk because some of the bonus is put in a “bank,” say, for five years. If over the next five years management performs poorly, and EVA drops, the “bank” account is depleted. Management incurs the risks and benefits just as owners do.

Joel Stern notes that in cases without an EVA incentive plan, employees suffer from a common problem. On average their fixed pay, salaries and pension, are too high, and their variable pay, profit sharing and share options, are to low (Ehbar XIX). Stern adds that size, not value, drives employees in typical incentive programs because size is positively correlated with increases in fixed pay and closely thereafter, variable pay, even if it destroys shareholder wealth. EVA protects shareholder interests by depositing variable pay into a deferred account that can be lost if value is eroded.

EVA, as a corporate measure and a predictive tool, generates mixed reviews in the business and academic worlds. AT&T’s Jim Meen says, “The correlation between MVA and EVA is very high. So when your driving your business toward EVA, your really driving the correlation with market value” (Kramer & Pushner, 43). Stern Stewart finds an R squared value of 60% based on 20 groupings of firms (Kramer & Pushner, 41). Contenders site statistical evidence to the contrary.

BCG-Holt calculates an R square, after removing 21 outliers, of 27%. Dodd and Chen report that EVA accounts for only 20.2% of the variation in stock returns for a sample of 500 companies, while ROA explains 24.5% of market returns (Kramer & Pushner, 43).

In their paper “An Empirical Analysis of Economic Value Added as a Proxy for Market Value Added,” Kramer and Pushner test the hypothesis that EVA is highly correlated with MVA. Simple regression analysis is used to test this hypothesis and other market determinants of market value such as NOPAT. First Kramer and Pushner test the rela