Question

What is the purpose of the EVA measure? In what ways is it similar to Residual Income? In what ways is it different? How does it differ from Return on Investment? Contrast these measures with the Balanced Scorecard

Answer 1

Economic Value Added

EVA is based economic profit, or how much value the investment adds to the business. EVA projects what the company's after-tax profit will be after subtracting the cost of capital in dollars from the projected net operating profit after taxes. Net operating profit is calculated by subtracting the associated depreciation and amortization expenses from the operating profit. Many businesses will also need to add increases in the bad-debt reserve and net capitalized research-and-development expenses. Companies will also have to subtract the cash spent to pay taxes. The result is the net operating profit after taxes

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a motivational, compensation-based management system that facilitates economic activity and accountability at all levels in the firm.

Several advantages claimed for EVA are:

• EVA eliminates economic distortions of GAAP to focus decisions on real economic results
• EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT
• EVA decouples bonus plans from budgetary targets
• EVA covers all aspects of the business cycle
• EVA aligns and speeds decision making, and enhances communication and teamwork

Residual Income

Residual income is also based on economic profit, but it is more reliant on accounting conventions. Residual income is the projected net operating income of the investment minus the business' dollar cost of capital. The net operating income is the difference between the income generated by the investment minus the associated expenses.

Considerations

The weaknesses of EVA and residual income are that both are based on projections, meaning the result of the investment could be a loss. Also, choosing which cost of capital value to use can be difficult and could distort possible returns.

Economic Value Added and residual income are methods businesses can use to evaluate investment opportunities. These methods evaluate how much money in excess of the business' cost of capital the investment is projected to generate. The difference between the two methods is in how each calculates the investment's projected revenues. EVA is the more complicated calculation, as it makes more adjustments to the accounting measures of the investment.

Minimum Rate of Return

Investors strive to have each of their investments provide a return greater than the returns of the alternative opportunities available. The rate of return for these other opportunities is called the cost of capital. Both EVA and residual income methods use cost of capital, which can be determined several ways. If a business is going to fund a project by issuing new stock, the cost could be the projected return the new stockholders will expect on their investment. If the company issues debt, it could use the interest rate associated with the loan. Or the business could use a composite of the investors' expected return rate and the interest rate on the business' outstanding debt. This is done by calculating the weighted average cost of capital.

Cost of Capital

To determine the cost of capital in dollar terms for EVA and residual income, the business would identify the value of the total investment in the project. The investment would include the money used for equipment purchases, loans taken out and personnel hired. The business would multiply this total by the cost of capital; the result is the dollar cost of capital.