NORTH-HOLLAND

The Distortions in Economic Value Added

(EVA) Caused by Inflation
Johann de Villiers

Economic Value Added (EVA) is calculated by subtracting the opportunity cost of

the capital from profits generated. This paper studies the extent to which EVA is
distorted by inflation, and finds that it cannot be used under inflation to estimate
actual profitability. The paper develops an adjusted EVA (AEVA) calculation
procedure which provides a better estimate of actual profitability under inflation. It
suggests that AEVA be used instead of EVA for financial decision-making under
inflation. AEVA also provides an alternative to inflation accounting, and could be
used under inflation to estimate actual profitability from conventional historical
cost accounts. © 1997 Temple University

Keywords: Inflation; EVA; Economic Value Added

JEL classification: M41; G30; E31

The wide-scale use of Economic Value Added (EVA) for financial decision-making
was first suggested by Stewart (1991). He recommended that managers should aim
to maximize EVA instead of maximizing profits. He also advocated the use of EVA
for "setting goals, evaluating performance, determining bonuses, communicating
with investors, and for capital budgeting and valuations of all sorts" [Stewart (1991,
p. 4)].
The main benefit of EVA is that it accounts for the opportunity cost of the
capital used by a firm. To calculate EVA, the analyst subtracts the opportunity cost
of the capital from the profits generated by the firm. EVA therefore focuses on the
profitable use of capital. When maximizing EVA, activities which result in positive
profits but return less than the cost of capital are discontinued, even though this
decreases overall profits.

Department of Business Economics, University of Stellenbosch, South Africa (JdV).

Address correspondence to: Dr. Johann de Villiers, Department of Business Management, Univer-
sity of Stellenbosch, Private Bag X1, Matieland, 7602, South Africa.

Journal of Economics and Business 1997; 49:285-300 0148-6195/97/$17.00

© 1997 Temple University PII S0148-6195(97)00001-5
286 J. de Villiers

A disadvantage of EVA is that it is based on accounting profits. It is well known

that accounting profit is often a poor proxy for economic profit. This discrepancy
between accounting earnings and economic earnings is exacerbated by inflation.
This paper studies the extent to which EVA, which is based on accounting
earnings, is itself distorted by inflation. The paper suggests an amended EVA
calculation to allow for the use of EVA under inflation.
The paper outlines the calculation of EVA, and discusses the difference be-
tween accounting returns and true returns. It then presents the model used in the
analysis, which consists of a theoretical firm in steady State under inflation making
a known true return. The EVA of this firm operating under inflation is then
calculated. The differences between the calculated EVA figures and the EVA
determined from the known true profitability of the theoretical firm shows the
extent to which inflation distorts the EVA figures. The paper finally suggests
amendments to the EVA calculations to account for the inflation distortions.

I. Economic Value Added

Economic value added is calculated by taking the spread between the rate of
return on total capital and the cost of capital, and then multiplying by the value of
capital committed in the business, as is shown in equation (1) below [Stewart (1991,
p. 136)]:

EVA = (r - c*) × capital (1)

where r is the rate of return on total capital, and c* is the cost of capital of the
firm.
According to Stewart (1991, pp. 85-86), the return on capital employed (r) can
be calculated by dividing the firm's net operating profits after taxes (NOPAT) by
the total capital employed in operations. In order to ensure that this return figure
is free from accounting distortions, Stewart (1991, p. 91) calculated NOPAT by
adjusting the income available to common shareholders. He added back preferred
dividends, provisions for minority interest, interest expenses (after tax) and what he
termed "increases in equity equivalents". The adjustment for increase in equity
equivalents is meant to "make NOPAT a more realistic measure of the actual cash
yield generated for investors" [Stewart (1991, p. 112)]. It includes adjustments to
correct for the effects of reserving for deferred taxes, valuing inventory by means
of the last-in-first-out (LIFO) instead of the first-in-first-out (FIFO) method,
amortizing goodwill, not capitalizing intangibles resulting from research and devel-
opment (R & D) and similar expenditures, and creating other precautionary re-
serves. Stewart also made corresponding adjustments to the capital figure. These
are designed to "gross up the standard accounting book value for common equity
to its economic book value".
Stewart (1991, p. 137) also proposed an alternative and equivalent formulation
of the EVA. This is obtained from equation (1) by multiplying through by capital:

EVA = NOPAT - c* x capital (2)

The Distortions in EVA Caused by Inflation 287

Stewart (1991, p. 167) recognized that it is inappropriate to compare EVA

among companies or business units of different size. To rectify this, he proposed
that E V A be standardized by dividing by the capital outstanding at the beginning
of the evaluation period, and multiplying by 100. This effectively expresses EVA as
a percentage of the beginning of period capital.
This paper shows that inflation causes a distortion in E V A in addition to the
accounting distortions that Stewart corrected for. The inflation-induced distortion
stems from the discrepancy between accounting return and true return. This
discrepancy exists in the absence of inflation. Because the discrepancy increases
with increased inflation, its effects are much more pronounced and the distortions
much more serious at high rates of inflation. The discrepancy between accounting
return and true return is discussed in the section below.

II. Accounting Return and True Return

The difference between accounting return and true return has been studied by
Harcourt (1965), Solomon and Laya (1967), Livingston and Salamon (1970), Fisher
and McGowan (1983), and Fisher (1984), who concluded that the differences
between the two are so large that the former cannot be used as an indication of the
latter. The effect of inflation on the discrepancy was addressed by Solomon and
Laya (1967), Kay (1976), Van Breda (1981), Kay and Mayer (1986) and De Villiers
(1989). They have shown that inflation exacerbates the discrepancy between
accounting and true return.
When using accounting data in a valuation model (of which EVA is an example),
an analyst is faced with the divergence between the reported accounting figures
and the economic concepts on which the valuation model is based. As Treynor
(1972, p. 41) explained:

The analyst treats earnings as if it were an economic concept. In view of his purpose
--attaching economic value to the firm--he can scarcely do otherwise. . . . The ac-
countant defines it (earnings) as what he gets when he matches costs against revenues,
making any necessary allocation of costs to price periods; or as the change in the
equity account over the period. These are not economic definitions of earnings but
merely descriptions of the motions the accountant goes through to arrive at the
earnings number. [Treynor (1972, p. 41)].

When trying to account for the discrepancy between accounting earnings and
true economic earnings, the major stumbling block is that the latter cannot be
measured directly. Had it been possible to measure the true economic earnings of
an actual firm, accounting conventions would surely have been changed to make it
possible. Accounting earnings do not measure true earnings but, as the latter
cannot be measured, analysts cannot determine the extent of the discrepancy.
Solomon and Laya (1967, p. 158) explained the dilemma as follows:

We are somewhat in the position of Plato's man in a cave who can see the shadows on
the ground outside, but who cannot directly see the objects which cast the shadows. Is
the length of an observable shadow always a correct indication of the height of the
actual object or are there systematic biases due to some other factors? Like Plato's
man, we can see at least a partial answer by trying a controlled experiment. Send out a
288 J. de Villiers

son or an animal of known height at the end of a string and observe its shadow under
various conditions, and thereby get more understanding of how well or poorly the
observable shadow measures the size of the human object under different circum-
stances. [Solomon and Laya (1967, p. 158)].
To study the effect of the discrepancy between accounting return and true return
on EVA, we shall follow a similar procedure. First, we will construct a theoretical
firm with a known built-in true return (the son or animal of known height). We will
then calculate its reported earnings and its E V A (observe its shadow) for various
combinations of assets employed and for different inflation rates (under various
conditions). The difference between the calculated E V A (length of shadow) and
the E V A determined from the known true profitability of theoretical firm (known
height) shows the extent to which inflation distorts the E V A figures.
We will start by constructing a theoretical firm with a known built-in true return
below.

I I I . Constructing a Theoretical Firm of Known Return

The information for calculating the true return of a firm is not available, but the
true return of a project can be measured (given the normal project cash flow
pattern consisting of one or more cash outflowed follows by cash inflows) [Solomon
and Laya (1967, p. 157)]. In order to illustrate the effect of inflation on a firm, we
will construct a theoretical firm consisting entirely of projects with the same
internal rate of return (IRR). Harcourt (1965) constructed firms of this kind in this
study of the relationship between accounting return and true return. The present
analysis uses a similar theoretical firm.
The theoretical firm in steady-state consists of (d + 1) projects, each with an
operating life of d years. One of the projects is just being started, one project is in
its first year of operation, one in its second year of operation and so forth until the
oldest project is in its last (dth) year of operation. In the absence of real growth,
each project is as large in real terms and (1 + i) times larger in nominal terms than
the project started one year earlier (where i is the rate of inflation). In steady state,
the firm will terminate its oldest project and start a new project every year.
Each of the projects which makes up the theoretical firm has the same IRR. The
firm, consisting entirely of projects with this known return, must have the same
IRR.

IV. Project Cash Flows

Each individual project consists of an initial investment in current, depreciable and
non-depreciable assets. The project runs for d years in which annual turnover,
expenses and cost of goods sold stay constant in real terms. In these subsequent
years, no investment is made in depreciable and non-depreciable assets. Current
assets employed increase in nominal terms in line with the nominal increase in
turnover, and this requires an annual investment in current assets. At the end of
the project, the depreciable assets are taken to have zero scrap value. Current
assets and non-depreciable assets have wound-up values equal to the initial
investments in real terms.
The Distortions in EVA Caused by Inflation 289

The length of the project is determined by the life of depreciable assets. In the
simplified model used in the present analysis, the depreciable assets have a given
operating life. At the end of this period, the maintenance cost of the depreciable
assets rises to infinity and the value of the assets drops to zero.
An example of a project employed in the present analysis is presented in
Table 1. This project has a life of four years and consists of an initial investment of
current (30%), depreciable (20%) and non-depreciable assets (50%). The rate of
inflation in this example is 10% per year, and the project requires investments in
current assets in subsequent years to maintain a constant real level of current
assets. The firm is assumed to pay income tax at a rate of 40%, and therefore
receives a tax credit from the straight-line depreciation of its depreciable assets. At

Table 1. Cash Flows and Net Operating Profit of a Four-Year Project with Initial
Investments of 30% Current Assets, 20% Depreciable Assets and 50% Non-Depreciable
Assets, an Internal Rate of Retum of 20% per Year, Paying Income Tax at a Rate of 40%
under Inflation of 10% per Year (Dollars)
Year 0 Year 1 Year 2 Year 3 Year 4

Panel A : C a s h flow calculations

Initial investment:"
Current assets -$300.00
Depreciable assets -$200.00
Non-depreciable assets -$500.00
Additional current - $30.00 - $33.00 - $36.30 - $39.93
assets b
Wound-u p value:C
Current assets $439.23
Non-depreciable $732.05
assets
Trading surplus d $267.38 $294.12 $323.53 $355.88
Tax e -$86.95 -$97.65 -$109.41 -$122.35

Total cash flow -$1,000.00 $150.43 $163.47 $177.82 $1,364.88

Panel B: N O P A T calculation

Trading surplus d $267.38 $294.12 $323.53 $355.88

Depreciation[ $50.00 $50.01) $50.00 $50.00
Net operating profit $217.38 $244.12 $273.53 $305.88
(before tax) g
Tax h $86.95 $97.65 $109.41 $122.35

NOPAT i $130.43 $146.47 $164.12 $183.53

a Total investment of $1,000.00 of which 30% is current assets, 20% depreciable assets, and 50% non-
depreciable assets.
b An additional investment of 10% of the previous year's balance of current assets has to be made to keep
the current asset level constant in real terms.
c Wound-up value constant in real terms, therefore nominal value increases by 10% per year over the
project.
~tTrading surplus represents sales minus cash expenses minus inventory processed. This net figure was
chosen to make the internal rate of return of the project equal to 20% per year. It stays constant in real terms
and increases in nominal terms by 10% per year.
e Tax payable is calculated from the net operating profit. This is shown in panel B below.
f Straight line depreciation of depreciable assets of $200.00 over four years.
g Trading surplus minus depreciation.
h Net operating profit times tax rate of 0.4.
' Net operating profit minus tax.
290 J. de Villiers

the end of the project, there are positive cash flows from the wound-up value of
current and depreciable assets. These are assumed to maintain their value in real
terms, and increase at the rate of inflation in nominal terms. The last cash flow
item in Table 1 is the annual trading surplus. To calculate the trading surplus,
inventory processed and cash expenses are subtracted from sales. All of these are
assumed to remain constant in real terms (increase at the rate of inflation in
nominal terms) over the duration of the project. The trading surplus, therefore,
similarly increases at the rate of inflation in Table 1. The project has an internal
rate of return of 20% per year. This has been ensured by choosing the appropriate
trading surplus for the project.

V. Calculating the NOPAT of the Firm

The net operating profit after tax (NOPAT) of the project started in year 0 is
shown in panel B of Table 1. The NOPAT of the firm is calculated by summing
across the current projects of the finn. During year 1, the firm operates four
projects. The project started in year 0 is in its first year of operation, and this
project reports a NOPAT of $130.43 (from Table 1). The project started in year
( - 1 ) is in its second year. This project is 1.1 times smaller than the project in
Table 1, and reports a NOPAT of $133.16 ($146.47, the NOPAT reported by the
project in Table 1 in its second year, divided by 1.1). Similarly, it can be calculated
that the project started in year ( - 2 ) , in its third year of operation, reports a
NOPAT of $135.64 ($164.12/1.12), and the project started in year ( - 3), in its last
year of operation, reports a NOPAT of $137.89 ($183.53/1.13). The NOPAT
reported by the firm is the sum of the NOPAT amounts reported by these four
projects, or $537.11.

VI. Calculating the Capital Employed by the Firm

To calculate the capital employed by the firm, we similarly sum across the current
projects of the firm. At the beginning of year 1 (end of year 0), the firm has assets
from the projects initiated in year 0, year - 1 , year - 2 , and year - 3 . The
non-depreciable assets are shown at their original cost, and the depreciable assets
have been depreciated straight line. Table 2 summarizes the book value of assets
employed by the firm.

VII. Calculating the EVA of the Firm

The finn reports NOPAT of $537.1 per year (calculated from Table 1 above) and
has capital employed of $3,400,00 (Table 2). None of the adjustments to profits
suggested by Stewart (1991, p. 91) apply to the simplified model used in this
analysis. The unadjusted NOPAT and asset figures can therefore be used to
calculate EVA. If the firm has a weighted average cost of capital of 15% per year,
its reported EVA is calculated from equation (2) as follows:
EVA = NOPAT - c* × capital
= $537.11 - 0.15 × $3,400.00
= $27.11. (2)
The Distortions in EVA Caused by Inflation 291

Table 2. Book Value of Assets Employed by a Firm Consisting of Four-Year Projects with
Initial Investments of 30% Current Assets, 20% Depreciable Assets and 50%
Non-Depreciable Assets, under Inflation of 10% per Year
Assets From projects started in:
Year 0 Year - 1 Year - 2 Year - 3

Current assets a $300.00 $300.00 $300.00 $300.00

Depreciable assets b $200.00 $136.36 $82.64 $37.57
Non-depreciable assets c $500.00 $454.55 $413.22 $375.66

Total assets per project $100.00 $890.91 $795.87 $713.22

Total assets employed by the firm: $3,400.00

a Current assets are valued according to the FIFO method, all projects therefore at current cost.
b Depreciable assets were depreciated straight line over four years. Year 0 project: at original cost. Year
- 1 project: three-quarters of original cost of $181.82. Year 2 project; half of original cost of $165.29. Year
- 3 project: quarter of original cost of $150.26.
c Non-depreciable assets are valued at their original cost.

Its standardized EVA is then:

Standardized EVA = ($27.11/$3,400.00) × 100%

= 0.80%.

The firm in tis example has a true return of 20% per year (being constructed
entirely from projects with that return). The firm has a weighted average after tax
cost of capital of 15% per year. The true standardised EVA of this firm is 5% per
year. (This is calculated by substituting for true return and cost of capital in
equation (1) and expressing the EVA as a percentage of the beginning of year
assets).
The reported standardized EVA of 0.80% is much lower than the true standard-
ized EVA of 5%. This numerical example illustrates the problem with EVA under
inflation. The reported EVA does not reflect the true profitability of the firm.
To evaluate the extent of the discrepancy between reported EVA and true
EVA, it is necessary to conduct a more general analysis than the single numerical
example presented above. Following a procedure along the lines of the numerical
example above, the standardized EVA reported by a firm consisting of projects
with a life of d years, in steady state, in any year k + 1, can be shown algebrai-
cally a to be:

Standardized EVAk+ 1 = (NOPATk+ 1 / A k - - C * ) " 100 (3)

1A technical working paper showing the derivations of the algebraic relationships presented in this
paper is available from the author on request.
292 J. de Villiers

where:

NOPATk + l = d .r. CAo, k

I '
_

+ [d. (r - i) •
Ii +ild
1--~l+r ]

_(l_t)(l +i~[ 1 d

+ d" (r - i). NA~, k (4)

and:

A~ = dCAo, k

+ DA~,k - t~.i 2 +
d . i 2 . (1 + i)d-1

1 d
(5)

and where NOPATk+ 1 is the net operating profit of the firm in year (k + 1); c* is
the cost of capital; A k is the total assets at the end of the year k (beginning of year
k + 1); CAo, k, DA~k, and NA~k are the current assets, depreciable assets and
non-depreciable assets, respectively, invested in year zero of the project initiated in
year k; d is the project duration; r is the true return of the firm (and also the
internal rate of return of projects); i is the inflation rate, and t is the income tax
rate.
To look at the effect of changing asset structure on EVA, the standardized EVA
has been calcualted for firms operating under the same conditions as the numerical
example above, but employing different types of assets. The results are shown in
Figure 1.
Each point within the three-cornered diagram in Figure 1 represents a particu-
lar combination of initial investments in current, depreciable and non-depreciable
assets. The horizontal axis shows the current assets, the axis on the left shows
non-depreciable assets and the axis on the right shows depreciable assets. These
are each shown as a proportion of the total investment in assets, so that the
proportions must always add to one. The bottom left corner of the diagram
represents a firm which only employs non-depreciable assets. The bottom right
comer represents a firm which only employs current assets. The top corner
represents a firm which only employs depreciable assets.
The Distortions in EVA Caused by Inflation 293

13

t,0 13
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 q ,0
I,

CURRENTASSETS
Figure 1. Standardised EVA of firms with project durations of four years, true returns of
20% per year, cost of capital of 15% per year, inflation of 10% per year, paying income tax
at a rate of 40%.

Each of the firms in Figure 1 has an internal rate of return of 20% per year and
a cost of capital of 15% per year. Each, therefore, has a true standardized EVA of
5% per year.
Only a small subset of the firms in Figure 1 reported the correct standardized
E V A of 5% per year. This inclues the all current asset firm. Some of the firms
reported a standardized E V A in excess of the true standardized EVA. This
includes the all depreciable asset firm with a reported 6.27% per year. The largest
majority of the firms reported a standardized E V A lower than the true standard-
ised EVA. This inclues the all non-depreciable asset firm, which reported a
negative standardized E V A ( - 3.53 percent per year).
It is clear that inflation distorts the EVA figures. If one uses the EVA to
estimate the productivity of firms, firms employing non-depreciable assets will
appear less productive than they really are, and firms employing depreciable assets
more than they actually are. Depending on what the E V A is to be used for, this
could result in inappropriate incentives, managers being compensated for perfor-
mance they did not actually achieve, inaccurate valuations and a misallocation of
resources.
The pattern of Figure 1 (non-depreciable asset firms showing a lower than
actual E V A and depreciable asset firms, a higher than actual EVA) does not apply
to all firms. This is evident form Figure 2, where the same calculations have been
294 J. de Villiers

1,0 0
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1.0

CURRENTASSETS
Figure 2. Standardised EVA of firms with project durations of 20 years, true returns of 20%
per year, cost of capital of 15% per year, inflation of 10% per year, paying income tax at a
rate of 40%.

undertaken for firms with a project length of 20 years (instead of the four years in
Figure 1).
Figure 2 shows a different pattern. The all current asset firm still shows the
correct standardized E V A (5% per year). All the other firms in Figure 2 show
a standardized E V A in excess of the true standardised EVA. The all non-
depreciable asset firm reported a standardized E V A of 6.36% per year, and the all
depreciable asset firm, 15.21% per year. It is obvious from these examples that
E V A is distorted by inflation. Under inflation it does not provide an unbiased
estimate of the productivity of assets employed by the firm.
The difference between reported E V A and true EVA is caused by two simulta-
neous distortions which occur in accounts drawn to historical cost conventions
under inflation. The one is the distortion of capital employed as a result of valuing
assets on a historical cost basis, and the other the distortion in accounting profits
under inflation. The sections below will discuss changes to the EVA calculation
procedure which are aimed at overcoming each of the two distortions.

VIII. EVA Based on Current Value of Assets

When assets are valued on a historical cost basis under inflation, their book value
is often a very poor proxy for their actual value. This is especially true for
non-depreciable assets and depreciable assets with a long life. To obtain an
economically useful EVA figure, it is necessary to base the calculations on a more
The Distortions in EVA Caused by Inflation 295

meaningful asset valuation. Our first recommendation is, therefore, to use current
values for determining the capital base in the E V A calculation.
To base the calculation on the market value of the firm would not be appropri-
ate. A firm realizing superior returns is more valuable than the assets it employs. If
one uses the market value of the firm as the basis of the EVA calculation, one
would find that this firm shows an E V A of zero. Its superior productivity is
reflected in a higher market value, and the effects cancel out when calculating
EVA. If one wants to use EVA to measure asset productivity, it would be more
appropriate to base the calculation on the current value of the a s s e t s the firm
employs, if put to their next best use.
The procedure to estimate this asset base will, in practice, depend upon the
availability of the data. In our theoretical model, the current value of assets is
determined by calculating what the present value of the remaining cash flows of
the projects would have been if the projects had shown a marginal return. The cash
flows of such a hypothetical marginal project (IRR of 15% per year) are shown in
Table 3. (Table 3 calculates what the cash flows of the firm discussed in Tables 1
and 2 would have been if the I R R were 15% instead of 20%.

Table 3. Cash Flows and Net Operating Profit of a Four-Year Project with Initial
Investments of 30% Current Assets, 20% Depreciable Assets and 50% Non-Depreciable
Assets, an Internal Rate of Return of 15% per Year, Paying Income Tax at a Rate of 40%
under Inflation of 10% per Year
Year 0 Year 1 Year 2 Year 3 Year 4

Panel A : C a s h flow calculations

Initial investment: a
Current assets -$300.00
Depreciable assets -$200.00
Non-depreciable assets -$500.00
Additional current -$30.00 -$33.00 -$36.30 -$39.93
assets a
Wound-up value: a
Current assets $439.23
Non-depreciable $732.05
assets
Trading surplus b $189.77 $208.75 $229.62 $252.58
Tax c -$55.91 -$63.50 -$71.85 -$81.03

Total cash flow -$1,000.00 $103.86 $112.25 $121.47 $1,302.90

Panel B: N O P A T calculation

Trading surplus b $189.77 $208.75 $229.62 $252.58

Depreciation a $50.00 $50.00 $50.00 $50.00
Net operating profit $139.77 $158.75 $179.62 $202.58
(before tax) d
Tax e $55.91 $63.50 $71.85 $81.03

NOPAT f $83.86 $95.25 $107.77 $121.55

a Items where the cash flow are identical to those in Table 1.

b Trading surplus represents sales minus cash expenses minus inventory processed. This net figure was
chosen to make the internal rate of return of the project equal to 15% per year. It remains constant in real
terms and increases in nominal terms by 10% per year.
c Tax payable was calculated from the net operating profit. This is shown in panel B below.
d Trading surplus minus depreciation.
e Net operating profits times tax rate of 0.4.
f Net operating profit minus tax.
296 J. de Villiers
The true value of the firm is the net present value of its future cash flows. The
hypothetical marginal firm has a cost of capital of 15% per year, and the return on
its projects is also 15% per year. The net present value of any complete project
undertaken by this firm is therefore equal to zero. The present value of all the
future projects not yet started is equal to zero, and the value of the firm is,
therefore, equal to the remaining cash flows of its incomplete current projects.
At the end of year 0, the firm has four uncompleted projects. These are the
projects which were initiated in year 0, year - 1, year - 2, and year - 3. Because
each of the projects is 1.1 times smaller than the one started a year later, it is
possible to calculate the remaining cash flows of each project from the figures
presented in Table 3 above. This is then used to calculate the value of the
hypothetical marginal firm in Table 4.
In general, it can also be shown algebraically 2 that the current value of the finn
can be determined from the firm characteristics as follows:

Vk = d. CAo,k

AI{t 1
c=l t(1( t
1+i] 1 d 1 d
,c, I)
d 1+i
+
1+i )d c* - i
1-- c1- -+- -~

+ d" NA A,k (6)

where Vk is the current value of assets employed by the firm, and c* the cost of
capital of the finn.

IX. EVA Based on Required Accounting Return

An amended E V A procedure also has to adjust for the distortion in accounting
returns resulting from inflation. To evaluate the extent of this distortion, consider
the accounting return reported by the hypothetical marginal firm shown in Tables 3
and 4.
The net operating profit after tax (NOPAT) of the project started in year 0 is
shown in panel B of Table 3. The NOPAT of the firm is calculated by summing
across the current projects of the firm. During year 1, the firm operates four

2 Derivations shown in technical workingpaper available from the author on request.

The Distortions in EVA Caused by Inflation 297

Table 4. Cash Flows Remaining from Existing Projects for a Firm Consisting of Four-Year
Projects with Initial Investments of 30% Current Assets, 20% Depreciable Assets
and 50% Non-Depreciable Assets An Internal Rate of Return of 15% per Year,
Paying Income Tax at a Rate of 40% under Inflation of 10% per Year

R e m a i n i n g cash flows of C a s h flows in:

projects s t a r t e d in: Year 1 Year 2 Year 3 Year 4

Year 0a 103.86 112.25 121.47 1302.90

Year ( - l)h 102.04 110.43 1184.46
Year ( - 2)' 110.39 1076.78
Year ( - 3) d 978.89

T o t a l cash flow 1285.19 1299.46 1305.93 1302.90

V a l u e of the Firm: 3703.74

Form Table 3 above.

h The project started in year - 1 is 1.1 times smaller than the project started in year 0, shown in Table 3.
The cash flows were calculated from Table 3, dividing the last three cash flows by 1.1.
' Calculated from Table 3 by dividing the last two cash flows by (1.112
a Calculated from Table 3 by dividing the last cash flow by (1.113.

projects. The project started in year 0 is in its first year of operation, and this
project reports a NOPAT of $83.86 (from Table 3 above). The project started in
year ( - 1) is in its second year. This project is 1.1 times smaller than the project in
Table 3, and reports a NOPAT of $86.59 ($95.25, the NOPAT reported by the
project in Table 3 in its second year, divided by 1.1). Similarly, it can be calculated
that the project started in year ( - 2 ) , in its third year of operation, reports a
NOPAT of $89.07 ($107.71/1.12), and the project started in year ( - 3 ) , in its last
year of operation, reports a NOPAT of $91.32 ($121.55/1.13). The NOPAT
reported by the firm is the sum of the NOPAT amounts reported by these four
projects, or $350.84. This means that the marginal firm shows a return on assets
(current value, $3,703.74, Table 4) of 9.47%.
The marginal firm has a true return of 15% per year, but shows an accounting
return (NOPAT on current value of capital employed) of 9.47%. This represents an
accounting hurdle rate for a firm with this asset structure. A steady state firm
employing assets in the same proportions as the firm in the numerical example
above, will contribute to economic value if its NOPAT exceeds 9.47% of its current
value. It would therefore be appropriate to use the required accounting return
(9.47%) instead of the cost of capital (15%) in an adjusted EVA calculation.
Consider the effect of using the required accounting return as the hurdle rate to
calculate an adjusted EVA for the firm in the numerical examples presented
earlier (Tables 1 and 2 above). This firm shows a NOPAT of $537.11 (calculated
from Table 2). The current value of the assets employed by this firm (remaining
cash flows of the projects of a hypothetical marginal firm with the same project
characteristics, as presented in Table 4) is $3,703.74. Given the required accounting
return of this firm of 9.47% (calculated above) the firm should report NOPAT of at
least $350.84 (9.47% of $3,703.74). The actual NOPAT reported by the firm is
$186.27 higher than the required NOPAT (reported NOPAT $537.11 and required
NOPAT $350.84). Expressing this as a percentage of the beginning of year assets
($3,703.74) yields a standardized adjusted EVA of 5.03%, which is close to the true
standardized EVA of 5%.
298 J. de Villiers

n . _

1,0 0
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 t,0

CURRENTASSETS
Figure 3. Required accounting returns for firms with project durations of four years, cost of
capital of 15% per year, inflation of 10% per year, paying income tax at a rate of 40%.

The required accounting return of a firm varies with type of assets employed.
The required accounting return can be calculated from equations (4), (with the cost
of capital substituted for the return), and (6). This has been done for four-year
project firms with a cost of capital of 15%, inflation of 10%, paying income tax at a
rate of 40%. The results are presented in Figure 3.
From Figure 3, it is clear that the required accounting return differs for firms
employing different asset types. The required accounting return of the current
asset firm is equal to the cost of capital. The required accounting return of the
non-depreciable asset firm is equal to the cost of capital minus the inflation rate.
The required accounting return of the depreciable asset firm is somewhere in
between, and depends upon the project length. This, in turn, depends upon the life
of depreciable assets.

X. A d j u s t e d E V A (AEVA) P r o c e d u r e
The procedure to calculate an adjusted EVA (AEVA) for a firm under inflation is,
then, as follows:
1. Restate the capital base in current values.
2. Determine the asset structure of the firm (proportions of current, depreciable
and non-depreciable assets employed).
3. Calculate the required accounting return from equations (4) and (6).
The Distortions in EVA Caused by Inflation 299

4. Calculate the AEVA:

A E V A = N O P A T - a* X (current value capital) (7)

where A E V A is the adjusted EVA, and a* is the required accounting return

of a firm with the given characteristics under the given condtions.
Equation (7) has been used to calculate the standardized A E V A for firms with a
project duration of four years, actual return 20%, cost of capital 15%, and inflation
of 10%. The results are shown in Figure 4.
The firms in Figure 4 all have an actual return of 20% and a cost of capital of
15%. They, therefore, all have a true standardized A E V A of 5%. It is clear from
Figure 4 that there is still a discrepancy between the true EVA and the AEVA.
This exists for depreciable assets only, and stems from the use of non-economic
(straight line) depreciation in the model. What is clear from Figure 4 is that A E V A
provides a much better estimate of productivity rates under inflation.
The A E V A concept has to be developed further. The procedures to calculate
A E V A from actual accounting data has to be tested in practice. More research
also has to be undertaken to see whether A E V A is valid in all the applications for
which E V A is suggested.

fl . _

1,0 0
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1,0
I.

CURRENTASSETS
Figure 4. Adjusted economic value added (AEVA) of firms with project durations of four
years, true returns of 20% per year, cost of capital of 15% per year, inflation of 10% per
year, paying income tax at a rate of 40%.
300 J. de Villiers

A E V A has two important potential areas of application. First, it can be used

under inflation for the wide range of financial decisions for which E V A is
suggested. It also has the potential to provide an alternative to inflation account-
ing. If operationalized, A E V A could provide a means to estimate actual profitabil-
ity under inflation, starting from conventional historical cost accounts.

XI. Conclusions
This paper shows that E V A is distorted by inflation and that it cannot be used
under inflation to estimate actual profitability.
The paper developed an adjusted E V A (AEVA) calculation procedure which
will provide a better estimate of actual profitability under inflation. The paper
suggested that A E V A be used instead of E V A for financial decision-making under
inflation. The A E V A concept provides an alternative to inflation accounting, and
could be used under inflation to estiamte actual profitability from conventional
accounts.
More research is needed to operationalize the concept and to test whether it is
appropriate to use in all the applications for which E V A has been suggested.

This paper has benefited from the helpful comments and suggestions of Daniel Leach, two anonymous
referees, and the participants at a conference of the Southern African Finance Association and a
seminar of the Business EconomicsResearch Group at the University of the Witwatersrand, Johannes-
burg, where earlier drafts were presented. EVA is a trademark of Stern Stewart & Co.

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