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Study Pack 40 EVA MVA

In corporate Finance Economic Value Added or EVA, a registered trademark of Stern Stuart is an estimate of a firm's economic profit- being the value created in excess of the required return of the companys investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the companies capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. This amount can be determined by making adjustments to GAAP or IFRS accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in. EVA Calculation: EVA = Net Operating Profit After Taxes a Capital Charge [the residual income method] therefore EVA = NOPAT - (c x Capital), or alternatively EVA = (r x Capital) (c x Capital) so that EVA = (r-c) x Capital [the spread method, or excess return method] where: o r = rate of return, and o c = cost of capital, or the Weighted Average Cost of Capital (WACC). NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs). The Capital Charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested. The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost. Another perspective on EVA can be gained by looking at a firms Return on Net Assets (RONA). RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (RONA Required minimum return) x Net Investments If RONA is above the threshold rate, EVA is positive. Table A Economic Profit Tree. Evaluation of an enterprise looking at the margins and %s.

Economic Profit tree you can see your strengths and limiters, you also see how 14 value drivers are connected, how they have trended over time, and how each ranks vs. the industry - all in an intuitive, visual snapshot. In 30 seconds, you can get an incredibly good sense of your business performance profile. You can also use the Economic Profit tree to break down value drivers into their subcomponents, so you can identify and focus on exactly the right trouble areas.

Comparison with other approaches Other approaches along similar lines include Residual Income (RI) and Residual Cash Flow. Although EVA is similar to Residual Income, under some definitions there may be minor technical 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 adjustments to NOPAT are unique to EVA. Although in concept, these approaches are in a 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. Other measures of shareholder value include: Added Value Market value added Total Shareholder Return.

Relationship to Market Value Added The firm's market value added, or MVA, is the discounted sum (present value) of all future expected Economic Value Added: (The image to the right shows the relationship with MVA and EVA. MVA can be establisehed by looking at the Extra value placed on the enterprise over and above its Assets. In other words what the investors see as its added Value. This should also represent the NPV of all future EVAs More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that the NPV of FCF = PV of EVA; since after all, EVA is simply the re-arrangement of the FCF formula. The background to using EVA & MVA Two measures of financial performance that are being applied increasingly in investor-owned and not-for-profit healthcare organizations are market value added (MVA) and economic value added (EVA). Unlike traditional profitability measures, both MVA and EVA measures take into account the cost of equity capital. MVA is most appropriate for investor-owned healthcare organizations and EVA is the best measure for not-for-profit organizations. As financial managers become more familiar with MVA and EVA and understand their potential, these two measures may become more widely accepted accounting tools for assessing the financial performance of investor-owned and not-for-profit organizations. Many recent articles have discussed the merits of two measures of financial performance, market value added (MVA) and economic value added (EVA).(a) With all the attention being given to these measures, financial managers should familiarize themselves with the definitions, rationale, and potential uses of these measures. Both MVA and EVA are applicable to investor-owned organizations; however, EVA also is an appropriate measure for not-for-profit organizations. MVA assesses the effect of managerial actions on shareholder wealth from an organization's inception, while EVA assesses managerial effectiveness in a given year. An important goal of any investor-owned organization is to maximize shareholder wealth. And, although the fundamental goal of shareholder wealth maximization is widely accepted, financial managers must recognize that maximizing shareholder wealth is not the same thing as maximizing the organization's total market value. An organization's total market value can be increased by raising and investing as much capital as possible, which increases the size of the organization and, therefore, often benefits managers. However, this strategy rarely is in the best interests of shareholders because it ignores the fact that shareholders have opportunity costs, and must earn a reasonable rate of return on their investments. Student Exercise: As part of your Group Study you will be required to include at least one slide on an evaluation of MVA and EVA.