1、Economic Value Added (EVA) is a financial performance measure being adopted by many companies in corporate America. This new metric, trademarked by Stern Stewart and Company, is a profit measure based on the concept of true economic income which includes the cost of capital for all types of financin
2、g. EVA provides a more comprehensive measure of profitability than traditional measures because it indicates how well a firm has performed in relation to the amount of capital employed. This article summarizes the EVA concept of measuring profitability, the EVA calculation and the benefits of adopti
3、ng an EVA framework.The EVA Concept of Profitability EVA is based on the concept that a successful firm should earn at least its cost of capital. Firms that earn higher returns than financing costs benefit shareholders and account for increased shareholder value. In its simplest form, EVA can be exp
4、ressed as the following equation: EVA = Operating Profit After Tax (NOPAT) - Cost of Capital NOPAT is calculated as net operating income after depreciation, adjusted for items that move the profit measure closer to an economic measure of profitability. Adjustments include such items as: additions fo
5、r interest expense after-taxes (including any implied interest expense on operating leases); increases in net capitalized R&D expenses; increases in the LIFO reserve; and goodwill amortization. Adjustments made to operating earnings for these items reflect the investments made by the firm or capital
6、 employed to achieve those profits. Stern Stewart has identified as many as 164 items for potential adjustment, but often only a few adjustments are necessary to provide a good measure of EVA.1 Measurement of EVA Measurement of EVA can be made using either an operating or financing approach. Under t
7、he operating approach, NOPAT is derived by deducting cash operating expenses and depreciation from sales. Interest expense is excluded because it is considered as a financing charge. Adjustments, which are referred to as equity equivalent adjustments, are designed to reflect economic reality and mov
8、e income and capital to a more economically-based value. These adjustments are considered with cash taxes deducted to arrive at NOPAT. EVA is then measured by deducting the companys cost of capital from the NOPAT value. The amount of capital to be used in the EVA calculations is the same under eithe
9、r the operating or financing approach, but is calculated differently. The operating approach starts with assets and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity
10、and equity equivalents to arrive at invested capital. Finally, the weighted average cost of capital, based on the relative values of debt and equity and their respective cost rates, is used to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value
11、. The resulting amount is the current periods EVA. The remainder of this article summarizes the financing approach because it emphasizes the significance of capital employed and illustrates how accounting rules impact the calculation of EVA. Exhibit 1 on page 33 shows a sample calculation of EVA. EV
12、A Calculation and Adjustments As stated above, EVA is measured as NOPAT less a firms cost of capital. NOPAT is obtained by adding interest expense after tax back to net income after-taxes, because interest is considered a capital charge for EVA. Interest expense will be included as part of capital c
13、harges in the after-tax cost of debt calculation. Other items that may require adjustment depend on company-specific activities. For example, when operating leases rather than financing leases are employed, interest expense is not recorded on the income statement, nor is a liability for future lease
14、 payments recognized on the balance sheet. Thus, while interest is implicit in the yearly lease payments, an attempt is not made to distinguish it as a financing activity under GAAP. Under EVA, however, the interest portion of the payment is estimated and the after-tax amount from it is added back i
15、nto NOPAT because the interest amount is considered a capital charge rather than an operating expense. The corresponding present value of future lease payments represents equity equivalents for purposes of capital employed by the firm, and an adjustment for capital is also required. See Exhibit 1 fo
16、r sample adjustments commonly used in the calculation of EVA. R&D expense items call for careful evaluation and adjustment. While GAAP generally requires most R&D expenditures to be expensed immediately, EVA capitalizes successful R&D efforts and amortizes the amount over the period benefiting the s
17、uccessful R&D effort. Another example of an EVA adjustment is the LIFO reserve increase. The increase is added back to profit because it converts inventory from a LIFO to FIFO valuation, which is a better approximation of current replacement cost. The full amount of the LIFO reserve represents past
18、holding gains and accordingly is added back to the equity component to reflect the capital invested by the firm in inventory not yet reflected in equity under GAAP. Other adjustments recommended by Stern Stewart include the amortization of goodwill. The annual amortization is added back for earnings
19、 measurement, while the accumulated amount of amortization is added back to equity equivalents. Goodwill amortization is handled in this manner because by un-amortizing goodwill, the rate of return reflects the true cash-on-yield. In addition, the decision to include the accumulated goodwill in capi
20、tal improves the real cost of acquiring another firms assets regardless of the manner in which the acquisition is accounted. While the above adjustments are common in EVA calculations, according to Stern Stewart, those items to be considered for adjustment should be based on the following criteria:M
21、ateriality: Adjustments should make a material difference in EVA. Manageability: Adjustments should impact future decisions. Definitiveness: Adjustments should be definitive and objectively determined. Simplicity: Adjustments should not be too complex. If an item meets all four of the criteria, it s
22、hould be considered for adjustment. For example, the impact on EVA is usually minimal for firms having small amounts of operating leases. Under these conditions, it would be reasonable to ignore this item in the calculation of EVA. Furthermore, adjustments for items such as deferred taxes and variou
23、s types of reserves (i.e. warranty expense, etc.) would be typical in the calculation of EVA, although the materiality for these items should be considered. Unusual gains or losses should also be examined and eliminated if appropriate. This last item is particularly important as it relates to EVA-ba
24、sed compensation plans. The Significance of the Capital Charge Under traditional financial reporting, a cost rate is not assigned for the equity used to finance operations. Thus, the use of net income as a performance measure is limited by the exclusion of that cost. In addition, when used in calcul
25、ations such as return on equity, net income also includes the accounting distortions included in its calculation and that of book value. EVA, on the other hand, through its adjustment efforts, seeks to eliminate the impact of accounting distortions while treating the impact of financing costs more c
26、omprehensively in its capital cost charge. Therefore, a truer measure of economic profit is provided by EVA than that provided by the use of traditional GAAP-based measures. This may be significant because some companies spend heavily on R&D and the accounting treatment for this and certain in tangi
27、bles is not included on GAAP-based balance sheets. EVA provides a way to compare performance among firms impacted by these accounting weaknesses. The specific amount of the capital charge for EVA is based on the amount of equity equivalents determined after adjustments, multiplied by the capital cos
28、t rate. The capital cost rate is based on the individual cost rates for both debt and equity. While the cost rate for debt can be readily determined, the rate for equity requires some effort. The cost for equity can be measured by using the capital asset pricing model, or other risk premium approach
29、es. Once that rate is determined, it is combined with the relative proportions of capital to produce the weighted average cost of capital (WACC). It is that overall rate, when combined with all capital including equity equivalents, that produces the overall capital charge used in EVA. After the capi
30、tal charge is calculated and deducted from NOPAT, the full extent of EVA s benefits can be observed, because all opportunity costs involved in the production of income have been measured and included in profitability. An example of the WACC is shown in Exhibit 1. EVA-Based Compensation Plans For fir
31、ms that reward managers based on performance, EVA can offer advantages over traditional profit-based plans. First, by tying compensation to a better performance metric, the company can achieve a better matching of its own objectives with those of the manager. Second, EVA can help reduce some conflic
32、ts of interest often associated with managers and profitability measurement. Because an objective of EVA is to eliminate the impact of accounting distortions on profitability and the influence of management in its calculation, EVA is a better representation upon which to reward executives. It should be noted that EVA measurement is not without subjective elements. It may be necessary to involve an independent committee to determine the appropriateness of specific EVA adjustments and how to best handle unusual situa
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