Question

Please do some research on the internet to learn about EVA (Economic Value Added), which is another tool to measure performance. First describe where you believe EVA is different from the Residual Value method.

Next please describe a specific situation, where performance measurement is needed. This can either be a real life scenario that you recall from your workplace or having learned about in the news, or a scenario that you are making up. Then pick one tool (EVA, Residual Income or ROI) and share with the class why you prefer this one over the other two.

Answer 1

EVA (Economic Value Added):

Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income technique that serves as an indicator of the profitability of projects undertaken. Its underlying premise consists of the idea that real profitability occurs when additional wealth is created for shareholders and that projects should create returns above their cost of capital.

In other words, Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis

Residual Income and EVA (Economic Value Added) are two methods that assess how much funds in excess of the business’ cost of capital the investment is projected to generate. Both residual income and EVA are based on the same principle the difference lies in the way they are calculated. While Residual Income uses operating profit in its calculation, EVA uses the net operating profit after tax. This is the key difference between residual income and EVA.

The only notable difference between residual income and EVA is resulting from tax payment since residual income is calculated on net operating profit before tax whereas EVA considers the profit after tax. The basis of these measures is to identify how effectively a company utilized its assets. EVA calculates the amount of asset utilization based on net operating profit after tax.While Residual income Method calculates the amount of asset utilization based on net operating profit

EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.

Formula for EVA= Net operating profit after tax- Finance expenses

Formula for Residual value = Net operating profit- Finance expenses

I can remember one instance at my workplace where my manager asked me to evaluate performance of division managers. company is having 2 division Northern and Southern. Norther region is having more EVA as compared to Southern region but Norther reason is having less RI as compared to Southern region. So I decided that Northern region manager has better performance as compared to southern region manager because EVA for northern region is higher. Also EVA is only which can be helpful when someone has to analyse the performance of management.

Economic Value Added (EVA) is a value based performance measure that gives importance on value creation by the management for the owners.

RI is not useful in this situation because RI is simply taking balance sheet figures for calculating average operating assets and operating income while EVA is adjusting the R&D expenses and assets relating to this along with non interest bearing liability. So EVA is more detailed and accurate way to measure the performace of management. Also in this case since RI of northen region is lower but EVA is higher becasue Northern region has certain assets which are not real assets like unamortised cost of R&D expenses, interest free current liabilties so these terms were adjusted for calcuation of average operating assets while calculating EVA. while in RI, we generally take average operating assets which is as it is in balance shete without any adjustment.

So in this situation although RI is lower for northern region but EVA is higher so Norther region manager will be considered as having better performance.

ROI is not helpful to analyse the performance measurement. It can helpful to analyse between 2 investment options. In other way it gives us Rate of return on ivestments made but it is not useful for performance measurement.