The Strengths, Weaknesses and Uses of the Economic Value Added Mode - Essay Example

?In the recent years, new arrivals techniques pertaining to performance measurement have gained plenty of financial managers’ attention and appreciation. Those techniques include “Residual Income”, “ROE”, “ROCE” “EVA” etc. However, every technique has its own strengths and weaknesses. The purpose of this article is the critical evaluation of the strengths and shortcomings of Economic Value Added (EVA). This paper also outlines some of the uses of Economic Value Added (EVA) and its contribution in facilitating the financial managers in taking different sorts of decisions regarding mainly the performance of employees. Economic Value Added (EVA) EVA is a relatively new technique of measuring financial performance of companies. This tool relies on three basic elements which are Net Operating Income adjusted after taxes (NOPAT), the investment amount and the weighted average cost of capital (Hansen & Mowen, 1997). EVA can be calculated as: EVA = After tax operating income – (investment in assets x weighted average cost of capital) The amount calculated under EVA is an absolute dollar amount. The amount calculated can be either have a positive value or can have negative value. The positive value shows that the organization has remained successful in generating more Net Operating Income After Tax (NOPAT), well covering the cost of investments that were employed. On the other hand, negative values shows organization’s failure in recovering the costs of investment as its cost of investments exceeded the Net Operating Income After Tax (NOPAT). Obtaining the positive value of EVA is the core objective of any organization. Strengths of EVA EVA has significant strengths which have increased its popularity tremendously. In the following discussion, more attention will paid on different aspects of EVA. 1. Better Measure EVA has turned out to be a better measure in terms of performance measurement of different stakeholders in organizations. Basically, the shortcomings of ROI lead to increase the use of EVA. The major pitfall of ROI was that when financial managers come to know that their performance would be measured according to ROI, they try their level best to increase the ROI as much as they can. All they want is to increase the ROI of their division despite of the fact that this instance of financial managers can hamper the overall performance of the organization. In order to achieve personal and individual goals, the broad objectives and goals of organization are put aside courtesy this technique. However, EVA is the technique which measures the performance of financial managers in an absolute dollar amount. This technique explains the absolute value added by the financial managers to their divisions and the organization as a whole. So the financial managers try to increase the EVA in comparison with other financial mangers to exceed the amount of EVA as much as they can, this effort causes benefits to financial managers, their divisions and the overall organization. 2. Absolute Measure of Performance One of the most promising strengths of EVA is that is explains the amount of value added by the financial managers in an absolute dollar amount. Other techniques such ROI measures performance in relative percentage terms which is not a true reflection of the performance of financial managers. The reason behind the failure of relative measures is that they do not take into account the size of amounts on which they are based. There are likelihoods that a financial manager earning too much with a huge amount of investments behind him/her, yet he/she end with lower ROI as compared to that financial manager who is responsible for lower magnitude of amounts. As a result, the true performance cannot be reflected if relative measures are used. On the other hand, EVA exactly explains the specific dollar amount that is added to the organization as a whole. 3. Similar to NPV This technique is very much similar to that of Net Present Value technique. In finance, the NPV technique has the importance of paramount because it actually describes about the dollar amount that can be generated if a particular project is opted. Similarly, EVA outlines the performance of division manager in dollar amounts as to how much value every division manager has added in the mainstream business of the organization. 4. Control over the Performance The use of EVA provides a level of relief to division managers as their performance will be measured against those values on which they have some sort of controls. Unlike, ROI or other relative measures, division managers always have a complaining attitude as they argue that these measures do not fully reflect their performances as the some financial decisions and dividend related decisions are not in their control, so it is not justified to judge their performance against that criteria on which they do not have any control. Weaknesses of EVA 1. Size Difference EVA has no control over the difference of sizes. The value that comes after calculating EVA for a large plant and the value that is calculated for EVA of a small firm will apparently have no difference but it will not portray any meaningful result and the comparative analysis of both the values will not be possible. In such case, ROI is utilized. EVA is considered to be more effective than ROI but it does not control the size difference for different organizations or organizational units. Hence, it is considered to be one of the weaknesses. 2. Financial Orientation EVA computes the result in numeric form that relies on the methods of expense recognition and revenue realization. Managers have a chance to manipulate the numbers by modifying their decision making processes. For instance, managers have the chance to manipulate the revenue recognition when they choose to send the orders of different customers according to the level of profit. The customers who provide high margins of profits in their order will be sent their orders before the end of accounting period however; customers who cannot afford to provide high margins of profit will receive a delay in their orders. This type of manipulation may lead to customer dissatisfaction and may harm the retention of customers. In another scenario, manager may plan to keep the fully depreciated assets and not to dispose them off. Keeping the obsolete equipment on the financial statements lowers the value of asset thereby increasing EVA, in this case the customer satisfaction and product quality will suffer as the obsolete and outdates equipments continues to be used. Uses of EVA There are various uses for EVA model. These uses make the lives of financial managers very convenient. Following are some basic uses of EVA: 1. Performance Metric The foremost use of EVA is to measure the performance of a division manager. The division managers work hard as they know that their performance will be measured against EVA which is an absolute measure. This performance metric provide emphasis to the division managers to improve their performances as their performance will be compared with that of others by the economic value that they have added to the organization as a whole. 2. Basis for Standard-Setting Process When the standards of the performance of division managers are set, EVA is highly focused. Each division manager is provided with a specific target of generating a fixed amount of EVA as his/her target objective to meet. Then the division managers perform their tasks and put their efforts in order to improve the amount of EVA, so that they can meet the target level of EVA, and if they go beyond the targets, there are likelihoods they end up with some other incentives such as bonuses, commission, etc as a result of generating more economic value to the company.   Base 1 2 3 4 5 6 7 8 9 10 Terminal Year EBIT (1-t) $ 27,259 $ 28,894 $ 30,628 $ 32,465 $ 34,413 $ 36,478 $ 40,366 $ 44,434 $ 48,663 $ 53,031 $ 57,511 $ 59,984 - WACC (CI)   $ 13,909 $ 13,881 $ 13,851 $ 13,819 $ 13,785 $ 13,354 $ 12,945 $ 12,554 $ 12,181 $ 11,823 $ 1,353 EVA   $ 14,985 $ 16,747 $ 18,615 $ 20,595 $ 22,693 $ 27,012 $ 31,489 $ 36,109 $ 40,850 $ 45,688 $ 58,631 Terminal EVA                     $ 945,659   PV   $ 13,348 $ 13,289 $ 13,158 $ 12,967 $ 12,728 $ 13,538 $ 14,148 $ 14,589 $ 14,888 $ 326,979   PV of EVA $ 449,633                       + Capital Invested $ 113,452                       + PV of Chg Capital in Yr 10 $ (33,064)                     = Firm Value $ 530,021                                                 WACC   12.26% 12.26% 12.26% 12.26% 12.26% 11.91% 11.56% 11.20% 10.85% 10.50% 10.50% ROC   25.47% 27.05% 28.74% 30.53% 32.44% 35.99% 39.67% 43.43% 47.25% 51.08% 465.39% Capital Invested   $ 113,452 $113,220 $ 112,975 $ 112,715 $ 112,439 $ 112,147 $ 112,017 $ 112,048 $ 112,242 $ 112,601 $ 12,889 Calculation of Capital Invested                         Initial $ 113,452 $ 113,452 $113,220 $ 112,975 $ 112,715 $ 112,439 $ 112,147 $ 112,017 $ 112,048 $ 112,242 $ 112,601   + Net Cap Ex   $ (685) $ (726) $ (769) $ (816) $ (864) $ (702) $ (537) $ (367) $ (189) $ -   + Chg in WC   $ 453 $ 480 $ 509 $ 540 $ 572 $ 572 $ 568 $ 560 $ 548 $ 531   Ending $ 113,452 $ 113,220 $112,975 $ 112,715 $ 112,439 $ 112,147 $ 112,017 $ 112,048 $ 112,242 $ 112,601 $ 113,133                             Cumulated WACC   112.26% 126.02% 141.47% 158.82% 178.29% 199.52% 222.58% 247.51% 274.37% 303.18%   The above table is exhibited which shows the in depth calculation and demonstration EVA based upon the projected cash flows of IBM. The financial statements of the year 2010 of IBM are used to estimate the future cash flows up to 10 years and then EVA model is applied on the dat. The results show that IBM has the potential to add value of around $449,633 in coming 10 years. References Association of Chartered Certified Accountants 2007, Economic Value Added,viewed on 14th November 2011, Brewer, Peter C., Chandra, Gyan and Hock, Clayton A, 1999, ‘Economic value added (EVA): its uses and limitations.’ SAM Advanced Management Journal, vol. 64, no. 2. Chen, Shimin and Dodd, James L., 2001, ‘Operating Income, Residual Income and EVA: Which Metric Is More Value Relevant?’, Journal of Managerial Issues, vol. 13, no. 1.   Ferguson, Robert Rentzler, Joel, Yu, Susana, 2005, ’Does Economic Value Added (EVA) Improve Stock Performance or Profitability?’, Journal of Applied Finance, Vol. 15, No. 2.   Grant, James Lawrence, Foundations of economic value added, John Wiley & Sons, New Jersey. 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