A question of values | ACCA Qualification | Students

by Steve Jay
01 Oct 2001
It is generally accepted that the objective of corporate financial management is to maximise shareholder wealth in the form of rising share prices and dividends. Whilst this is obviously in the interest of shareholders it should also benefit society as a whole. This is because it should lead to the most efficient companies finding it easiest to raise new share capital and thus ensure that society’s scarce resources are allocated and managed most efficiently. Unfortunately history shows us that accounting profit measures often appear to have little correlation with share price performance. This is particularly true in new-economy companies, many of which have poor profit records but who have demonstrated large increases in wealth for their investors during the 1990s.

Market Value Added

Before proceeding with a look at economic value added it is important that we clarify our measure of shareholder wealth. Imagine two quoted companies A plc and B plc. Both firms are entirely equity financed. Both have a start of year stock market equity capitalisation of £400 million. A raises £20 million via a rights issue and invests it in a project that adds £100m to the present value of its future earnings. B raises £150 million via a rights issue and invests in a project that adds £120m to the present value of its future earnings. Table 1 demonstrates the changes to equity market capitalisation and shareholder wealth.

Table 1 Changes in Stock market value

Opening Total Value (equity market capitalisation)
Addition to Present value of earnings stream
Closing Total Value (equity market capitalisation)£500m£520m
Changes In shareholder wealth
Increase in Total Value (equity market capitalisation)
Funds subscribed by shareholders
Market value added for the period £80m£80m(£30m)

It is clear that although company B has the greater increase in market capitalisation it has decreased the wealth of its shareholder’s as the present value of the future income generated by its new project is less than the funds invested. Company A on the other hand adds £80m to the wealth of its investors.

This is a simple but important point. Shareholder wealth is not simply the increase in stock market value over the period; rather it is the increase in stock market value less funds subscribed by shareholders.

This concept can be enlarged to cover the whole life of the business. Over a longer time period the market value added is the difference between the cash that investors have put into the business (either by purchase of shares or the reinvestment of potentially distributable profits) and the present value of the cash they could now get out of it by selling their shares.

The link with NPV
None of the above is particularly new. NPV is a well-established rule that measures the impact that new projects will have on shareholder wealth. Table 2 adds some more detail to the two projects being considered by companies A and B.

Table 2 Cash Flows

Company A Project
Company B Project
t0 Initial investment(20)(150)
t1-t4 Net cash flow pa
CAPM based required rate of return15%
Net Present value Project A = (20) + Annuity factor for 4 years @ 15% * 35.03
=(20) + 2.855 * 35.03
Net Present value Project B = (150) + Annuity factor for 4 years @ 20% * 46.35
=(150) + 2.589 * 46.35
Both of these figures correspond with the Market Value Added in the period and the NPV rule should guide managers to select projects that maximise shareholder wealth.

Economic Value Added
So far we have established that the prime objective of financial management is to maximise investor wealth and that this can be achieved by using NPV in decision making. What is lacking is an operating performance measure for management that will guide managers to maximise NPV and thus shareholder wealth.

Traditionally operating managers are judged on accounting profit based measures (controllable profit, return on investment, etc), which we have noted, often lack correlation with shareholder wealth and largely ignore NPV. It seems very strange that we expect managers to evaluate new projects on the basis of NPV but that we subsequently ignore NPV in appraising managerial performance.

Economic value added attempts to cure this problem. Economic value can be defined as:
Cash Earnings before interest but after tax* – an imputed charge for the capital consumed.

*often referred to as NOPAT (net operating profit after tax)

In this way a manager’s operating performance is judged after charging a £ amount for capital funds used.

It will be noted that this is very similar to residual income, a performance measure you will have considered in earlier studies.

Crucially the present value of the economic value added figures equals the NPV of the project.
Economic Value added is sometimes referred to as EVA®. EVA® is the registered trademark of Stern Stewart and Co who have done much to popularise and implement this measure of residual income.

Table 3 shows the calculation of economic value added for our two projects and demonstrates its equivalence with NPV.

Table 3

Company A Project
ear beginning Capital employed (net)2015105
Net of tax operating cash flow
Economic depreciation*
Imputed capital charge (15% of capital employed)
Economic Value added27.0327.7828.5329.28
Company B Project   
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation*
Imputed capital charge (20% of capital employed)(30)(22.5)(15)(7.5)
Economic Value added
Equivalence with NPV 
Company A Economic Value Added
PV factors @15%
Present Value
Total Present Value = £80.04 million = Project NPV (difference due to rounding)
Company B Economic Value Added(21.15)(13.65)(6.15)1.35
PV factors @20%
Present Value(17.62)(9.47)(3.56)0.65
Total Present Value = (£30million) = Project NPV
*Economic depreciation measures the true fall in the value of assets each year through wear and tear and obsolescence. Although depreciation would not normally be charged in calculating discounted cash flow in this case it must be recovered from a company’s cash flow “to provide investors with a return of their capital before they can enjoy a return on their capital.” G Bennett Stewart . Alternatively it could be viewed as the capital expenditure the firm would have to make each year to maintain its capital base. In this example, for simplicity, economic depreciation is assumed to occur on a straight-line basis though clearly other patterns are possible.

The Linkages

To recap
The increase in shareholder wealth
= Market value added
= Project NPV
= Present Value of Economic Value added.

Therefore if we tell managers that their performance will be judged upon economic value added, this should result in the maximisation of NPV and thus shareholder wealth. We now have a performance measure that corresponds exactly with NPV based decision-making. Proponents therefore recommend that manager’s and division’s operating performance should be measured on an economic value added basis.

Some complications
Geared companies

Not all companies are financed entirely by equity – many fund substantial parts of their plant and equipment by using debt finance. The principles of economic value added still apply. Cash earnings before interest but after tax are charged for capital at a rate that blends the after tax cost of debt and the cost of equity in the target proportions the firm would plan to employ (rather than the actual mix used in a particular year). Imagine that company A financed its project by 50% equity finance and 50% risk free debt finance and that this was considered to reflect the target capital structure. To reflect this higher gearing A’s cost of equity finance increases to 18.5%. Its post tax cost of debt is 7%. This gives a weighted average cost of capital for the project of

18.5% * 50% + 7% * 50% = 12.75%

The capital charge to the project will now be at 12.75% of year beginning capital employed. Note that interest on the loan should not be deducted from the net of tax operating cash flow as it is allowed for in the imputed capital charge. The tax relief on interest should not be allowed for in the tax bill, as once again this is included in the capital charge. Students will note that this is similar to the approach taken in estimating net cash flow in NPV calculations. This approach is illustrated in Table 4 together with other adjustments.

Table 4 XYZ plc Profit and loss account year ended 31/12/2000 (Unadjusted)

Sales Revenue50 
Cost of sales
Interest paid1.6 
Amortisation of goodwill1.3 
Profit before tax13.6 
Tax paid (30%)
Available to equity
XYZ plc Balance Sheet as at 31/12/1999 (unadjusted)
Fixed assets (net)
Current Assets
Less Current Liabilities98 
Net assets40 
Ordinary shareholders funds40 
XYZ plc Profit and loss account year ended 31/12/2000 after adjustments
Profit before tax
Interest paid
1.6note 1
2.1note 2
Advertising2.3note 3
Goodwill1.3note 4
Adjusted Tax bill
4.56note 5
Adjusted profit
16.34note 7
XYZ plc Balance Sheet as at 31/12/1999 after adjustments
Ordinary shareholders funds
27note 1
R&D13.4note 2
Advertising15note 3
Adjusted capital employed104.3 
Adjusted return16.34 
Required Return £104.3 m * 15% =
15.645note 6

Economic value added and reported accounting results
Published accounting profit figures are more complicated than operating cash flow less economic depreciation as featured in Table 3. For reasons of prudence, losses are often recognised at an early date and accruals accounting makes many timing adjustments to cash flow in converting it to accounting profit.

As we are really interested in economic profit rather than accounting profit these adjustments have to be eliminated or added back in. The consulting firm Stern-Stewart have identified 164 performance measurement issues in its calculation of EVA® from published accounts. The adjustments mainly involve:

  1. Converting accounting profit to cash flow
  2. Distinguishing between operating cash flows and investment cash flows

They include such issues as treatment of stock valuation, revenue recognition, bad debts, the treatment of R&D, advertising and promotion, pension expenses, contingent liabilities etc. Whist it is unlikely that you would have to make 164 adjustments in the exam some simple changes may be required! Some of these are demonstrated in Table 4 which includes a calculation of EVA® from a set of published results. See Table 4.

Conclusion: this company has added value for its shareholders.

  1. Interest paid is added back as this will be charged in the imputed capital charge. Borrowings are added to the capital base as profits must cover the cost of borrowings (see geared companies above).
  2. R&D is considered an investment in the future in the same way as expenditure on capital equipment. £2.1m is therefore removed from the P&L account. At the same time the last say 5 years R&D expense (assumed £13.4m) is added back to the balance sheet. This will increase the capital base and thus the imputed capital charge. A small charge for R&D may remain in the P&L to reflect the economic depreciation of the capitalised value.
  3. Advertising is a market building investment and is removed from the P&L. The last say 5 years advertising expense is added to the capital base (assumed £15m). A small charge for advertising may remain in the P&L to reflect the economic depreciation of the capitalised value.
  4. Goodwill represents the premium paid for a business on acquisition. Again this is an investment in the future and similar adjustments as for R&D and advertising apply. The cumulative advertising write off of (assumed) £8.9m is added to the capital base.
  5. The tax figure will include tax relief on debt interest. As this will be allowed for in the weighted average cost of capital it should be adjusted out. The tax bill will rise to 4.08 + (30% * £1.6m)= £4.56m.
  6. This is an assumed 15% WACC applied to the adjusted capital employed. Note that WACC would be calculated following the approach outlined in geared companies above.
  7. No adjustment is made for depreciation as this is assumed to approximate economic depreciation on physical assets as discussed above.

Arguments for and against Economic Value Added

  • It makes the cost of capital visible to managers. Under conventional management accounting performance measures the only profit and loss charge for capital is depreciation on the asset. Under the economic value added approach managers will also be charged the financing cost of capital employed. This should cause managers to be more careful in investing new funds and to control working capital investment. It can also lead to under-utilised assets being disposed of. To improve their performance managers will have to:
    – Invest in positive NPV projects; or
    – Eliminate negative NPV operations; or
    – Reduce the firms Weighted average cost of capital.
    Or hopefully all three.
  • It supports the NPV approach to decision making. If managers pursue negative NPV projects they will eventually find that the imputed capital charge outweighs earnings and will lead to a deterioration in their reported performance.


  • Economic Value added does not measure NPV in the short term. Some projects have poor cash flows at the beginning but much better ones at the end (and vice versa). Projects with good NPVs may show poor economic value added in earlier years and thus be rejected by managers with an eye on their performance measure. Managers who have a short-term time horizon (possibly due to impending promotion or retirement) could still make decisions that conflict with NPV and thus the maximisation of shareholder wealth.

If we return to projects being considered by companies A and B but this time alter the pattern of cash flows (but not the NPVs) the point will be clearer. Table 5 illustrates this point.

Table 5 Cash Flows

 Company A Project
Company B Project
t0 Initial investment
CAPM based required rate of return
NPVs are unchanged and should therefore have the same effect on Market value added as before.
Economic Value added computation
Company A Project 
Year beginning Capital employed (net)2015105
Net of tax operating cash flow
Economic depreciation
Imputed capital charge
(15% of capital employed)
Economic Value added
Company B Project 
Year beginning Capital employed (net)
Net of tax operating cash flow
Economic depreciation
Imputed capital charge
(20% of capital employed)
Economic Value added
The present value of the economic value added figures is still equal to the projects NPV (check it for yourselves) but the year-by-year distribution of economic value added has changed. Managers with a short term time horizon may well accept company B’s project but reject company A’s project
  • Validity of EVA® adjustments
    Part of the problem with economic value added in the short-term lies in the accounting measurement of profit. In table 5 company A’s project might show poor cash flow earlier on due to large investments in R&D. To a certain extent this problem can be removed by using the adjustments proposed by Stern and Stewart covered above. However Brealey and Myers question if these adjustments to accounting profit are sufficient. They cite the case of Microsoft and question whether its capital base has been understated in published Stern Stewart EVA® figures. “The value of its intellectual property- the fruits of its investment in software and operating systems is not shown in the balance sheet” This would undervalue its capital base and result in imputed capital charge being too small and thus overstate its EVA®

Shareholder Value Added (SVA)
Shareholder value is a much-discussed concept and many companies now express a commitment to it. It should be noted however that economic value added is simply one way of measuring the increase in shareholder wealth achieved by the company.

Kevin Mayes gave a useful overview of the various shareholder value metrics in a students’ newsletter article in the November/December 2000 edition. Of these competitors to EVA® Shareholder Value Added is also included in the Paper 3.7 syllabus.

Shareholder Value Added involves calculating the present value of the projected future free cash flows of the business. Any increase in this present value should result in an equivalent increase in market value added and thus increase shareholder wealth.

Free cash flow is the cash flow available to a company from operations after interest expenses, tax, debt repayments and lease obligations, any changes in working capital and capital spending on assets needed to continue existing operation (i.e. replacement capital expenditure equivalent to economic depreciation)). Although different definitions of free cash flow exist they all relate to cash flow after replacement capital expenditures. Free cash flow in our definition represents the cash available to shareholders, which in principle could be used to invest in new positive NPV projects, paid out as dividend or used for share repurchase. The present value of this free cash flow should equal the current equity market capitalisation of the business, and any changes in this present value (less shareholder funds subscribed) represent the market value added.

Table 6 gives an example of the types of calculation involved.

Table 6

A company prepares a forecast of future free cash flow at the end of each year. A period of 15 years is used as this is thought to represent the typical time horizon of investors in this industry. The company’s CAPM derived cost of equity is 10%. During 2000 a rights issue of £5m is made which is invested in a project that will increase future earnings. Note that present values are calculated at a cost of equity as free cash flow is measured after debt servicing costs i.e. it represents a return to equity holders. If debt interest and principal payments had been excluded from the free cash flow calculation then the present value would have been calculated at the WACC as this version of free cash flow represents a return to both equity and debt holders. The resultant present values would then represent the value of debt plus equity in the company. The value of equity could be calculated by subtracting the stock market value of debt.

Free cash flow forecast as at 31 /12/99               £m
Operating costs-4.000-5.000-6.000
Debt repayments0.000-4.0000.000
Working Capital
Replacement capital Expenditure0.000-3.0000.000
Free cash flow3.500-2.5006.000
PV factors @10%the company’s cost of equity
Present Value of free cash flow
Total present value36.337  
Free cash flow forecast as at 31 /12/00
Operating costs-5.000-6.000-6.000
Debt repayments- 4.0000.0000.000
Working Capital-0.500-0.500-0.500
Replacement capital Expenditure-3.0000.0000.000
Free cash flow-2.5006.0007.000
PV factors @10%the company’s cost of equity0.9090.8265.870
Present Value of free cash flow-2.2734.95641.090
Total Present Value43.773  
Present value of free cash flow as at 31/12/9936.337  
Present value of free cash flow as at 31/12/0043.774  
Increase in present value
Funds subscribed by shareholders in the year
Market value added

This company has increased the wealth of its shareholders.

Arguments for and against the Shareholder value added approach


  • It takes a multiperiod view and should therefore overcome some of the “short termism” of EVA.


  • The estimates of future free cash flow are very subjective and are very difficult to verify. This technique would almost be impossible for outsiders to the business use.
  • The time horizon over which free cash flow is forecast is difficult to determine. If you use a short period you lose the present value earned in later years, but if a long period is used the forecasting of cash flows becomes very subjective.


Shareholder value is high on the agendas of many companies as shareholders increasingly look for competitive rates of return on their investments.

The two metrics discussed here draw heavily on traditional financial management and management accounting theory. EVA, SVA and free cash flow are all included in the Paper P4 syllabus and are 'fair game' for future exam questions.

References and Acknowledgements

  1. G. Bennett Stewart III, EVA Fact or Fantasy, Journal of Applied Corporate Finance, Summer 1994.
  2. R. Brealey & S. Myers, Principles of Corporate Finance, McGraw Hill, 6th Edition, 2000.
  3. K. Mayes Shareholder Value, ACCA Students’ Newsletter, November/December 2000.


Thanks to Scott Goddard for his valuable comments on the drafts of this article.