A Study On Economic Value Added Accounting Essay

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Economic Value Added (EVA) is a trademark of the Stern Stewarnt Consulting Organisation. Stern Stewarnt maintains that the implimentation of a complete EVA-based financial managment and intensive compensation system gives managers both better information and superior motivation to make decisions that will create the greatest share holder wealth in any publicly owned a private organisation.

It is argued that linking performance to profit breeds a short termist boom bust culture. For instrance, a firm might adopt a cost minimisation programme to increase profits and, to this end, make immediate redundacies. This short term decision would most likely trigger problems in the medium to the long term for the business. This is one of the concern that EVA directly addresses, and the principal success of EVA as a performance metric is the link with long term wealth maximisation and discount factor techniques. Studies have shown that companies that adopt EVA as a performance measure outperformed their peers by 8.5% annually, and for those companies operating in a declining market this jimps to over 12% per annum.

The real benefits are realised when EVA is further linked to management compensation packages. In this scenario it was found that companies outperformed their peers by 57% over a five year period (Stern Stewart,2005).

Stern Stewart argues that EVA is the financial performance measure that comes closer than any other to capturing the true economic profit of an organisation, and is the performance measure most directly linked to the creation of shareholder wealth over time. EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk. The formula is as follows:

EVA= net operating profit after tax - WACC Ã- book value of capital employed

Stern et al (ed 2001) suggest that 'when fully implemented' EVA will be 'the centerpiece of an integrated financial management system that incorporates the full range of corporate financial decision making'. It is argued that the following advantages can be gained from the adoption of an EVA- based approach to performance measurement:

Profits are shown in the way shareholders count them

Company decisions are aligned with shareholder wealth

A financial measure is used that line managers understand

The confusion of multiple goals is ended.

Other approaches along similar lines incluse Residual Income Valuation (RI) and redidual cash flow. Although EVA is similar to residual income, under some definitions there may be minor tecnical differences between EVA and RI ( for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adustments to Nopat are unique to EVA.

Although in concept, these approaches are in sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency.

Difference between Economic Value Added (EVA) and Market Value added (MVA) and Cash Value Added (CVA)

Economic Value Added (EVA) is a performance measure developed by Stern Stewart & Co that attempt to measure the true economic profit produced by company. It is frequently also referred to as " economic profit", and provides a measurement of company's economic success over a period of time. Such a metric is useful for investors who wish to determine how well a company has produced value for its investors, and it can be compared against the company's peers for a quick analysis of how well the company is operating in its industry.

Economic profit can be calculated by taking a company's net after tax operating profit and sutracting from it the product of company's invested capital multiplied by its percentage cost of capital. For example, if a fictional firm, Cory's Tequila Company (CTC), has 2005 net after tax operating profits of $200,000 and invested capital of $2 million at an average cost of 8.5%, then CTC's economic profit would be computed as $200,000 - ($2million Ã- 8.5%)=$30,000. This $30,000 represents an amount equal to 1.5% of CTC's invested capital, providing a stadardized measure for the wealth the company generated over anf above it's cost of capital during the year.

Market Value Added (MVA), on the other hand, is simply the difference between the current total market value of company and the capital contributed by investors (including both shareholders and bondholders). MVA is not a performance metric like EVA, but instead is a wealth metric, measuring the level of value a company has accumulated over time. As a company performs well over time, it will retain earnings. This will improve the book value of the company's shares, and investors will likely bid up the prices of those share in expectations of future earnings, causing the company's market value to rise. As this occures, the difference between the company's market value and the capital contributed by investors (its MVA) represents the excess price tag the market assigns to the company as a result of it past operating successes.

Cash Value Added (CVA),is a measure of the amount of cash generated by a company through its operations. It is computed by subtracting the 'operating cash flow demand' from the 'operating cash flow' from the cash flow statment.

Cash value added is similar to economic value added but takes into consideration only cash generation as a apposed to economic wealth generation. This measure helps give investors an idea of the ability of a company to generate cash from one period to another. Generally speaking the higher the CVA the better it is for the company and for investors