Strengths, weaknesses and uses of the Economic Value Added - Essay Example

Running head: STRENGTHS, WEAKNESSES AND USES OF THE ECONOMIC VALUE ADED MODEL Strengths, weaknesses and uses of the Economic Value Added Insert Insert Course Title Insert Instructor’s Name 22nd November 2011 Introduction Economic Value Added (EVA) model also referred to as economic profit refers to the value created above the shareholders investment. Basically, shareholders and other investors are more interested in EVA since it depicts the actual returns that a company makes after the cost of financing the company’s capital is deducted. In order to obtain the economic profits, the cost of capital must be less than the return on the firm’s capital employed. This paper candidly evaluates the uses of Economic Value Added model in a business as well as its strengths and weaknesses. Uses of EVA EVA is obtained by subtracting the cost of capital from Net Operating Profit After Tax (NOPAT).In this regard, Al Ehrbar (2008) depicts that it is a useful tool for measuring the extent to which value has been lost or added on the business performance. After accounting for the various aspects covered by the balance sheet, EVA indicates the amount of the residual income. There are various factors that cause an increase of EVA. First, if capital employed does not increase and the NOPAT increases. Secondly, EVA increases if the additional capital invested generates more returns than the cost of capital. EVA can also increase if the capital that was earlier invested in a business is divested if it fails to cover the cost of capital used by a business. Economic Value Added=Operating income obtained after tax-(Investment in assets * weighted average cost of capital) (Bennett, 1991). If the EVA figure is negative, it means that a business is consuming more capital instead of creating wealth. On the other hand, a positive EVA indicates that the company has earned more after tax revenue than the costs incurred in generating that revenue. The examples below indicate the procedure of calculating EVA. Example 1 EVA for Pitt Products Company (figures in $000) Income from operations 364 Earnings before interest and taxes 364 Pretax income 320 Net income 192 Net profit after tax 192 Capital employed 1200 Capital Cost Rate 8.7% In this case EVA=NOPAT-Capital Charge NOPAT=Net profit after tax + Total Adjustments-Tax savings on Adjustments =192+ (42-50)-(42+50)*0.4 =248.4 Capital charge = Capital * Capital Cost Rate = 1,200*0.087 =248.4-104.4 =104.4 Therefore EVA =248.4 -104.4=144. This implies that in 1998, Pitt Products had a positive EVA of $ 144,000. Example 2 The information below gives information as depicted by XYZ Company 2000 financial statements (figures in $000). Total Capital $1,400 Weighted Average Cost of Capital =1 1.3% Gross profit 736 Selling, General & Administration Expenses 400 Taxes 134 Sales 2,436 Cost of goods sold 1,700 NOPAT = Operating Profit-Taxes Operating Profit =Gross Profit- Selling, General & Administration Expenses = 736-400=336 Therefore NOPAT=336-134=202 Capital Charge =11.3%*1500=169.5 This implies that EVA of XYZ Company =202-169.5=32.5 XYZ has an EVA of $32,500. This indicates that the company creates wealth for shareholders equity. Evaluation of employee’s performance In addition to measuring of business performance, Baran et al, 2007 argues that EVA is also used in evaluating employee’s performance. In order to effectively evaluate the productivity of the employees, EVA should be accompanied by appropriate measures that entail all the performance attributes that are vital for the achievement of long-term benefits. This involves use of balanced score card that defines the major aspects that contributes to a long term success. These aspects include learning perspective and innovation, customer perspective, financial perspective and internal business activities perspective. In addition, Baran et al, 2007 stipulates that In order to create a balanced scorecard, managers must consider the strategic goals of the firm. This implies that managers must take into consideration whether they aim at achieving a competitive edge through differentiation or cost leadership. This is followed by selecting the suitable measures that address each of the four aspects that determines the long-term success of a company. In order for a score card to represent manager’s performance and depict a balance between results and processes, it is prudent for it to contain between 11 and 17 reinforcing measures that come from all the four aspects that defines the success of a business. Valuation of shareholders The growth of earnings per share and high returns on shareholders equity has been some of the major aspects that companies have for a long time used to measure the extent to which they have maximize the shareholders return. However, Griffith (2006) depicts that earnings derived from shares do not portray changes caused by inflation and changes of additional capital allocated to cater for financial growth. This makes the two measures not to be explicitly linked to enhancement of company performance. Other measures that make earnings per share not to be reliable in terms of measuring economic value of money include ignoring the time value of money, failure to consider divided policies and use of alternative accounting techniques (Griffith, 2006). Focused managers are therefore maximizing shareholders value by combining the company share prices and the dividends. This is calls for valuation of business an aspect that is possible by use of EVA as a valuation method Performance bonuses and motivation According to Baum et al, (2004) the use of EVA as a performance measurement tool makes it an ideal approach through which companies can use to reward the best performing managers by giving bonuses and other incentives. Strengths of EVA Residual performance metric One of the strengths that make Economic Value Added to be adopted by many organizations is its ability to summarize the value added by all other metrics of business performance. Through combining other metrics into a single statistics, companies are able to determine and compare their financial performance between various financial years. Capital charge As mentioned earlier, earnings per share do not effectively indicate the value of the shareholders equity. EVA ensures that the deficiency caused by earnings per share on the balance sheet is collected. This means that EVA recognizes that capital used by companies to generate growth is not free. This implies that the growth is not free and as such EVA allocates a certain charge on the capital used to acquire the growth. Operational metric According to Griffith (2006), Economic Added Value is effective as an operational metric. In this way, it helps business managers to come up with strategies on how to create value. Some of the ways applied by managers in order to create value on their companies include reducing expenses, reduction of the cost of capital or through increasing capital investment. Limitations of EVA Despite the merits of EVA over ROI, the model has four major limitations as discussed in the section below. Size differences One of the major limitations of EVA is that it does not take into consideration the size of divisions within the same company. For instance, a larger division or company indicates a higher EVA as compared to a smaller division. ROI considers the utilization of the company assets. Companies that use ROI are therefore in a position to clearly determine the most successful department regardless of their sizes (Graham et al, 1934). Financial orientation According to Joel and John (2010) Economic Value Added is computed by use of two major accounting concepts. These include expense recognition and revenue realization. In this regard, managers who are focused at attracting investors by the use of EVA can manipulate figures in order to portray their companies as having remarkable performance. For example, finance managers can manipulate the revenue generated in a particular accounting period by delaying some customer’s orders and filling others (Erik, 2009). At the end of the accounting period, only the profitable orders are reflected, thus indicating a positive EVA. Another example concerns manipulation of the discretionary expenditure. For example, if a finance manager cancels a training program undertaken by an outside company, the accounting statement indicates a reduction of the expenses as a result of the savings incurred after the cancellation of the training program. This results to a higher EVA. Short-Term Orientation In order to motivate managers for their innovative ideas and efforts to attain the company goals, most companies offer compensation to such managers in the current accounting period. When used as a tool of employee’s motivation, EVA does not apply this concept. One of the major aspects of EVA as argued by Weaver (2001) is that it overemphasizes the need to attain instant positive results. This causes demotivation to the managers thus becoming hesitant in investing in new ideas and technologies. Even though the costs incurred by the project that is initiated by an innovative manager, are recognized by the accountants in the current accounting period, the benefits of the project are recognized after some time. As a result, the increase of costs depicts a low EVA in the current period thus leading to manager’s demotion or even laying off (Phillip et al, 2010). Results Orientation Just like other forms of financial metrics, EVA does not provide adequate solution to managers who are not devoted to accounting principles but their main aim is to provide a product that creates value to the customers. For example, operations managers are more interested in emulating measures that are non-financial in nature for example the quantity of yield. In order for the non accountant managers to improve their yield, they focus on nonfinancial measures instead of financial strategies. It is imperative to note that managing business process calls for regular control of costs and other aspects related to daily operations of a company. Bennett (1991) argues that due to the fact that EVA is one of the major result-oriented financial indicators that are computed at the end of an accounting period, it offers little solution to managers who are responsible to undertake business processes although out the accounting period. Single-period limitation EVA indicates the performance of a company in the current accounting period. Thus it has no implication on the performance of a business in future. Conclusion The increased need for diversification of investment portfolio by the managers is an aspect that should entail the contribution of all the stakeholders. Even though EVA has a number of limitations, it offers more benefit to shareholders as compared to other metrics of measuring business performance. In order to make if more effective in the day to day operations of a company, it is prudent for companies to create a strong linkage between the accountants and the managers who are responsible for daily business processes. References Al Ehrbar.2008. EVA, the Real Key to Creating Wealth. New York: Wiley. Baran, D., Hrotko, L. And Olejnik P. 2007. Economic Value Added – EVA. Economics and Management.London: Sage. Baum, L., Sarver, L and Strickland, T. 2004. EVA, MVA and CEO Compensation: Further Evidence. American Business Review, June 2004. Bennett, S.1991. The Quest for Value. New York: HarperCollins. Erik S.2009. The Value Mindset.New York: Wiley. Graham, Benjamin; Dodd, David L. 1934. Security Analysis: Principles and Technique. New York: McGraw-Hill. Griffith, J. 2006. EVA and Stock Performance. The Journal of Investing. summer 2006. Joel, S and John S.2010. The EVA Challenge. New York: Wiley. Phillip, E., Pfeifer; David, J and Reibstein 2010. Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. New Jersey: Pearson Education, Inc. Weaver, S. 2001. Measuring Economic Value Added: a survey of the practices of EVA proponents. Journal of Applied Finance, Fall/Winter, pp. 7 – 17. Read More