In this week’s discussion we will touch lightly on EVA. Some major companies liv

Question

In this week’s discussion we will touch lightly on EVA. Some major companies live and die byEVA. For example, at General Electric, more capital isallotted only to divisions that pass the EVA threshold, and divisions that regularly flunk are sold off. It’s a simple, but powerful, approach that looks at acompany’s numbers from an economist’s point of view and factors in not just explicit costs but also implicit costs in measuring a firm’s profitability.Take a look at  http://www.sternstewart.com/?content=proprietary&p=eva andhttp://www.investopedia.com/articles/fundamental/03/031203.asp and tell us what you think

Explanation / Answer

EVA or Economic Value added -- a concept initially devised by Stern Stewart& co. means economic profit-- that compares net operting profit to total cost of capital.

The formula for calculating EVA is:

EVA = Net Operating Profit After Tax - (Capital Invested x WACC)

As is eident from the above , the calculation of EVA involves taking into account three values- NOPAT available in the financial statements,total capital invested and the WACC.

For feasibility /economic viability of carrying on /discontinuing a particular department/ section , EVA approach is highly recommendable or rather mandatory. Net income -from- financial-statements- approach is useful only for investors and the general public.

Even though this is a little more time- consuming , EVA approach is the real measure that provides accurate information about shareholder's wealth. As ultimately, it is the value generated from funds invested in a business. If the economic value added measurement turns out to be negative, it means a business is destroying value on the funds invested in it. In such case, it is essential to review all of theabove said components to see which areas of a business can be adjusted to create a higher level of economic value added. If the total economic value added remains negative, the business should be shut down.

The cocept of EVA makes top managers responsible for a measure that they have more control over - the return on capital and the cost of capital are affected by their decisions - rather than one that they feel they cannot control as well - the market price per share.

And most importantly, EVA approach is influenced by all of the decisions that managers have to make within a firm - the investment decisions and dividend decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing decision affects the cost of capital.In calculating the cost of capital , the management takes int account all the implicit costs - any notional/opportunity/implied costs-- ie. anything other than the explicit costs.

In these ways, EVA is the most appropriate and recommended approach , to decide on the profitability or otherwise of any business decision.

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.