Economic Value Added
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 c at the beginning of the year by the spread between its return on capital c 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 th
O'Byrne and Stewart suggest at first glance that earnings and EVA have about the same level of success in explaining market value. The variance explained ranges around 32%. Taking into account the two characteristics listed above, the explanatory power of their model increases to 42%. an 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 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. My results using a simple linear regression model parallels Kramer and Pushner's results. EVA in 1997 has the highest R square factor, at 33%, but is far from the results calculated by Stewart. EVA's R squared increased dramatically since 1992. This is consistent with the economic trend of the 90's, so the increase may not necessarily reflect an increase in EVA due to internal factors, but an external factor, such as the greatest economic expansion in recorded history. All four factors consistently increase from 1992 to 1997. Lastly, GAAP incentives can be ineffective motivators. For example, a retiring officer's pension plan is linked to earnings. During their last year they might skimp on R&D to boost earnings because their pension plan is tied to performance. Operating earnings often serve as the benchmark for management compensation. Management has the incentive to negotiate a target that is easy to beat. Managers aim low, insuring their bonus. Trade loading is a second example of how GAAP can affect management decisions concerning bonuses and owner interests. 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 relationship between the level of MVA and the level of EVA using the SS1000. In all cases the level of MVA positively relates to both NOPAT and EVA in the same and prior periods. However, in all cases, NOPAT explains more of the total variation in MVA than EVA" (O'Byrne & Stewart 44). This suggests that the level of NOPAT is not only a better proxy but also a better predictor of corporate performance than the level of EVA. Results for weighted least squares, change in MVA and variations are described graphically i
Some common words found in the essay are:
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Approximate Word count = 2100
Approximate Pages = 8 (250 words per page double spaced)
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