Relevant to ACCA Qualification Paper P5
In the first part of this article, we considered the rise in popularity of Economic Value Added – or EVA – as an alternative to traditional performance measurement systems. This second part focuses on interpreting the calculated EVA, and its use as both an organisational and divisional performance measure.
Interpreting the calculated EVA
When using EVA to assess the performance of an organisation or a division, the following should be considered:
Use of EVA as an organisational performance measure
EVA is a performance measure that can be used to assess the performance of the directors of a company. The idea is that directors will be motivated to improve EVA in one of four ways:
As such, EVA is a useful tool for assessing the performance of the directors of a company and should motivate them to maximise the wealth of the shareholders.
Use of EVA as a divisional performance measure
EVA can also be used as a performance evaluation tool for divisional managers. In decentralised organisations, divisions are effectively companies in their own right, with the head office acting as a holding company. As such, using EVA encourages divisional managers to maximise the wealth of the division. Divisional managers may not have sufficient autonomy to make decisions about financing or gearing, so will not be able to change the weighted average cost of capital (WACC). However, using EVA should ensure that divisional managers only invest in projects where the return on the projects exceed the costs of the company’s capital.
Consistency with net present value
The ultimate measure of how much value an organisation creates is the net present value of the projects it invests in. Net present value shows the return on projects in excess of the cost of financing them. If the financial markets are functioning efficiently, it should be the case that the market value of an organisation is the same as the book value of the net assets of the organisation, plus the present value of future cash flows. Maximising shareholders’ wealth therefore means maximising the net present value of future cash flows.
It can be shown that residual income – and therefore EVA – is consistent with net present value. Consider the following example:
A company will invest $10,000 in a new project. The $10,000 represents investments in non-current assets. The project will last for three years, and will generate cash inflows of $5,000 in year one, and $7,000 in years 2 and 3. The assets will have no residual value at the end of the life of the project. The relevant discount rate is 10%.
The net present value of the project can be calculated as follows:
Sum of discounted residual income (606 + 2,478 + 2,502) = $5,586. This is the same as the net present value calculated using the cash flow method above. The small difference of $2 is due to rounding.
Note 1: Straight-line depreciation has been used, so annual depreciation is $10,000/3.
The finance charge is 10% of the net book value of the assets of the project at the start of each year:
Year 1 Year 2 Year 3
Opening net book value 10,000 6,667 3,334
Less depreciation (note 1) (3,333) (3,333) (3,334)
Closing net book value 6,667 3,334 0
Finance charge 1,000 667 334
This relationship between residual income – and therefore EVA – and net present value is important.
Return on capital employed and return on investment
So what of those well-known, traditional profit-based measures, return on capital employed and return on investment? We normally use the former description when discussing organisations, and the latter when describing divisions of organisations. A commonly used version of these calculations is as follows:
Return on capital employed (ROCE) = profit BEFORE interest and tax x 100
shares + reserves + long-term liabilities
Return on investment (ROI) = controllable profit x 100
In principle, using these measures to assess the performance of the managers of an organisation should not conflict with the goal of maximising shareholder value. However, the following problems may exist:
These three potential problems should not exist when using EVA because:
Disadvantages of EVA
EVA suffers from several disadvantages, such as:
In spite of these disadvantages, EVA as a performance measure does assess the value created by managers, so is a more appropriate tool for measuring the performance of commercial organisations than profit-based ones.
Nick Ryan is lead tutor for performance management subjects.