AbsLracL

This article discusses economic value added (EVA), a financial measure introduced by the consulting firm Stern
Stewart & Company., which claims that EVA is the only true indicator of business and management performance.
The article briefly explains how EVA is calculated and demonstrates that EVA is identical to residual income, an older
financial measure largely abandoned by U.S. companies years ago. Yet EVA is by no means the panacea that some
authors have suggested. This is demonstrated by showing inconsisten- cies in definitions of EVA and various general
limitations of using EVA. Companies that use EVA should understand the inconsistencies involved, then take the
limitations of EVA explicitly into account.
-897,.9

This paper aims to present a narrative literature review oI 112 papers published on the EVA Irom
1994 to 2008. It provides a classiIication scheme, identiIies the gaps in existing literature and
suggests the direction Ior Iuture research. Studies are classiIied and presented on the basis oI the
time period, issues covered, distribution oI literature in various sources, methodology used,
country-wise publications and contributions made by the researchers on the concept. The studies
conducted in the developed countries have largely been Iound to be supporting EVA though
there are certain studies in these countries too that consider conventional measures as better tools
oI corporate perIormance reporting. However, in developing economies less numbers oI studies
are available supporting the empirical validity oI the concept as a corporate perIormance
measurement tool. The concept oI EVA has gained signiIicant attention in the advanced
economies, but implementation issues and its validity is under debate all over the world. The
paper presents a comprehensive literature review and a critical analysis to move towards the
advances in EVA. It may be a very useIul source oI inIormation to the researchers and managers
who wish to understand and implement EVA and carry out Iurther research on the diverse issues
oI this interesting and value adding perIormance metric.
Focus Take-Aways
Rating (10 is best)
Overall Applicability Innovation Style
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EVA and VaIue-Based Management
A Practical Guide to mplementation

by S. David Young and Stephen F. O'Byrne
2000 McGraw-Hill
493 pages
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Ideas & Trends
W The primary goal of any business should be increasing shareholder (owner) value.
W Economic Value Added (EVA) is the best available metric for measuring value.
W EVA is a measure of economic (not accounting) profi t. An EVA calculation shows the
difference between the cost of capital and the return on that capital.
W You can calculate EVA for the company and for individual business units or divisions.
W mplementation of EVA is company-specifi c; no single template fi ts all companies.
W Some companies' structures are ill-suited for EVA, but the principles of value-based
management can still apply to them using different metrics.
W To reap EVA's benefi ts, you must adopt it as a performance metric from the top down.
W Employees won't change their behavior to align with shareholders' interests unless
they are motivated to do so, with both short- and long-term incentives.
W Unlike stock options, EVA performance targets can reward managers for
improvement in the performance of their individual divisions or business units.

W EVA is a measurement system, not a strategy unto itself.
9 7
EVA and Value-Based Management Copyright 2003 getAbstract 2 of 5
ReIevance
What You WiII Learn
n this Abstract, you will learn: 1) The defi nition of EVA and why it is a superior measure
of shareholder value; 2) Which types of companies can benefi t most from EVA; and 3)
How EVA can be the centerpiece of an effective management compensation policy.
Recommendation
Kudos to S. David Young and Stephen F. O'Byrne, management consultants who largely
steer clear of their industry's usual empty catchphrases and superfi cial hype. nstead,
their lucid explanation of the importance of shareholder value takes center stage. The
heftiness of EVA and Value-Based Management may be daunting, but most readers
will be satisfi ed with Part 's strategic overview. The concepts reappear in Part
accompanied by a wealth of technical details, calculations and case studies to help
fi nance professionals with nitty-gritty implementation of EVA (Economic Value Added)
programs. The book honestly assesses EVA's power to motivate managers, noting that
some companies just are not well-suited for this performance metric. getAbstract.com
prescribes this book to corporate executives who have overdosed on consultant jargon
but still want to drive value growth in their companies, and to fi nance specialists who
seek a comprehensive roadmap to EVA implementation.
Abstract
The Signifi cance of SharehoIder VaIue
Although businesses exist to create value for their owners, corporate executives and
managers do not always act to maximize shareholder value, because of perceived confl icts
with other goals. Shareholder value does not necessarily confl ict with good citizenship

toward employees, customers, suppliers, the environment and the local community.
Companies that respect those constituencies tend to outperform others, suggesting that
value can be delivered to shareholders only if it is fi rst delivered to other constituencies.
Value-based management strategies have been around as long as business has existed.
Every useful performance metric attempts to measure changes in shareholder value.
Economic value added (EVA) is the best metric available. The others each have
signifi cant drawbacks:
1. Traditional income measures, including net income and earnings per share, can be
easily manipulated, and they do not account for the cost of equity.
2. Market-based measures, including market value added (MVA), excess return and
future growth value (FGV), can only be calculated for publicly-traded entities.
3. Cashfl ow measures, including cashfl ow from operations (CFO) and cashfl ow return
on investment (CFRO), include neither the cost of equity nor the cost of debt.
EVA is highly accurate because it includes the cost of debt fi nancing and equity fi nancing.
Since you can calculate EVA for private entities or for divisions within companies, you
can use it as a motivational tool deep within your organization. Traditional managers
understand that their companies need to control operating costs and succeed in the
commercial markets. Today, companies also must compete in the capital markets by
keeping their cost of capital low.
"Great business
leaders, past and
present, have
always known
about EVA without
calling it that.
"EVA is much
more than a measurement
system.

t's also an instrument
for changing
managerial behavior.
t is about
changing mindsets,
getting managers
to think
differently about
their work.
EVA and Value-Based Management Copyright 2003 getAbstract 3 of 5
&nderstanding EVA
EVA measures residual income; that is, it measures the difference between a fi rm's
cost of capital and return on capital. EVA is expressed as either a positive or negative
currency amount. To calculate EVA, assign a cost to each component of your fi rm's
fi nancing (equity and short- and long-term debt). The resulting weighted average cost
of capital (WACC) is one of EVA's most important components. t requires transparent,
credible calculation, because there are differing ways of assigning costs to capital (in
particular, to equity fi nancing).
The simplest way to calculate EVA is to subtract capital charges (invested capital
multiplied by the WACC) from net operating profi t after taxes (NOPAT). Clearly, you can
increase EVA several ways, including: 1) increasing NOPAT; 2) lowering the WACC; and
3) reducing invested capital (divesting functions that do not contribute to value growth).
Often, companies refi ne their EVA calculations by making accounting adjustments to
overcome the inherent limitations in generally accepted accounting principles (GAAP).
More than 150 possible accounting adjustments are available, but most EVA companies
make fi ve or fewer. The most important criterion when considering an accounting
adjustment is whether it will have a direct effect on managers' incentives to create value.
EVA and orporate uIture

Paying managers for performance is a backward-looking practice, but the capital
markets assign value on a forward-looking basis. Therefore, companies that pay for past
performance may be unwittingly paying their managers to undermine value creation.
f you are going to implement EVA-related performance measurement throughout your
company, all affected employees need to understand the goal, as well as how their actions
contribute to meeting it. n this respect, the EVA's popularity parallels the 1980s "total
quality management trend. Like quality, value is every employee's responsibility. To
this end, management and employee training programs are a crucial component of any
EVA plan.
mplementing EVA is a highly company-specifi c process. Companies are more likely to
benefi t from EVA if they have these characteristics:
W The corporate structure consists of relatively autonomous business units, rather than
one large unit or a matrix organization with substantial shared resources.
W Strong managerial wealth incentives are tied to business unit performance, rather
than corporate-wide goals (as with stock or stock options) or the discretion of the
compensation committee.
W The CEO is an enthusiastic advocate, rather than going along with something he/she
doesn't fully understand or support. EVA implementation should begin at the top.
W Business unit heads have long tenure and thus are motivated by long-term incentives.
reating an EVA-based ompensation PIan
The four primary factors in creating a compensation plan are:
1. Align management performance and shareholder value.
2. Create strong wealth leverage, so employees work hard and make diffi cult decisions.
3. Employee retention risk, particularly in bear markets or industrial slumps, when
performance-based compensation may decrease through no fault of the employee.
4. Cost of the compensation plan to shareholders.

"Think of EVA as
a means of revealing
to the rest of
us the insights that
Jack Welch and
other great managers
have always
had at a deep intuitive
level.
"Managers must
think like owners,
not like employees,
but such a
change is not possible
unless managers
are paid to
think this way.
"Capital has attained
a degree
of mobility that is
unprecedented in
human history, and
it will go anywhere
it is most appreciated.
EVA and Value-Based Management Copyright 2003 getAbstract 4 of 5
The ratio of the percent of change in management wealth to the percent of change
in shareholder wealth is called the wealth leverage ratio. The ratio is 1.0 for a
sole proprietor, which is why a 100% correlation between shareholder wealth and
management wealth is referred to as entrepreneurial wealth leverage. The ratio is far
lower for managers who own only a tiny percentage of shares, and whose divisions
%

only contribute a fraction to stock price. This is why stock options are an effective
motivating tool only for top executives.
Management buy-outs (MBOs) create strong wealth leverage, but at a high risk
including the creation of high levels of debt and an increased risk of default. EVA is
as powerful as an MBO in creating incentives and focusing managers on a single goal,
without the leverage risk.
The EVA-based ManageriaI Bonus PIan
A traditional managerial bonus plan awards a target bonus for meeting expectations.
These expectations can be linked to share price or any other metric. The amount of bonus
that can be earned by exceeding expectations is capped. The cap controls costs, but it
provides no incentive to improve performance above a certain level. Subpar performance
is punished by reducing the bonus, with no further disincentive once the bonus bottoms
out at zero. The EVA bonus plan also includes a target bonus, plus a fi xed percentage
of excess EVA improvement (since EVA is measured in currency and can be positive or
negative). The fi xed percentage component results in an uncapped bonus level, on the
upside or the downside.
Removal of the upside cap creates an unlimited incentive for improvement. The removal
of the downside cap could theoretically result in a negative bonus, but the bonus bank
eliminates that possibility. With a bonus bank, a portion of any bonus exceeding the
target bonus is banked for payout in future years. Thus, managers can still get a bonus
in years when EVA declines more than expected, which lessens retention risk. For any
given year, no bonus is paid only if the bonus bank balance is negative, due to long-term
decreases in EVA. This bonus model has three major limitations:
1. The bonus plan can backfi re if the corporate or national culture spurns strong
wealth incentives. Older managers near retirement may see strong wealth leverage
as too risky.
%

2. n highly cyclical industries, creating strong wealth leverage while avoiding large
negative bonus bank balances in downtimes, can only be achieved by setting compensation
above market levels, resulting in a high cost to shareholders.
3. n start-up companies or emerging markets, EVA is not the best performance metric.
Two possible alternatives to EVA bonus plans are 1) equity carve-outs (as distinguished
from pure spin-offs), which create equity incentives at lower levels of the company
while retaining the corporate structure, and 2) creation of a tracking stock, which allows
performance to be refl ected in a smaller division's share price without the disclosure
requirements of a carve-out.
PossibIe Objections to EVA
1. Because business-unit EVA calculations include the cost of capital, the prospect of a
lower short-term EVA and the resultant bonus may discourage managers from investing
in new projects. Potential solutions include:
"Quite simply,
senior corporate
executives are too
often paid to worry
about things other
than creating
value.
"Value creation is
the responsibility
of every employee,
not just top managers
and fi nance
specialists.
"There is no substitute
for judgment,

experience,
and an intimate
knowledge of capital
markets and
investor expectations.
"EVA implementation
is a largely
pointless exercise
unless the company
intends, at
least eventually, to
tie EVA to management
compensation
in some
way.
EVA and Value-Based Management Copyright 2003 getAbstract 5 of 5
W Using a bonus bank to make sure long-term EVA is not sacrifi ced for short-term EVA.
W Deriving a portion of managers' bonuses from nonfi nancial value drivers, such as
product innovation, customer satisfaction, market share or employee safety.
W Treating large investments as being made gradually to smooth short-term EVA.
W Using stock options to provide a long-term incentive.
2. Measurement can be diffi cult at divisional and subdivisional levels if divisions share
resources or if vertical integration allows more control over the value chain. EVA
calculations must not allow divisional managers to boost their own EVA at the expense
of other divisions and the corporation. Potential solutions include:
W Choosing other value drivers that serve as a proxy for EVA at lower levels.
W Grouping divisions and using EVA to evaluate the group.
W Linking part of managers' bonuses to EVA in other divisions.

W Allocating costs to divisions based on divisional profi tability.
W Using activity-based costing (ABC) instead of allocating costs based on volume.
W Approaching transfer pricing in new ways, such as internal auctions or arbitration.
What Went Wrong?
n the early 1990s, several well-known companies, including Monsanto, Georgia-Pacifi c
and AT&T, trumpeted adoption of EVA as a performance metric, only to abandon it
within a few years. The companies that dropped EVA shared three main trends in the
way they implemented it in the fi rst place, differing from fi rms that continued to use
EVA successfully.
1. Their compensation plans capped bonus levels, instead of allowing an unlimited upside.
2. They did not use bonus banks. nstead they paid full bonuses in the year in which
they were earned. This increased retention risk.
3. Their compensation committees were allowed considerable discretion in determining
bonus levels, diluting the power of EVA targets to focus managers on a single goal.
These companies did not get good results because they did not follow EVA best practices.
About The Authors
S. David Young is a professor at NSEAD, and a consultant on EVA and value-based
management for several American, European and Asian companies. Stephen F. O'Byrne
is president and co-founder of Shareholder Value Advisors, nc., and former senior vice
president at Stern Stewart & Co.
Buzz-Words
Bonus bank / Economic Value Added (EVA) / Value-based management / Wealth
leverage (ratio) / Weighted-average cost of capital (WACC)
"One of the most
important tasks of
a company's chief
fi nancial offi cer is

to select that capital
structure that
minimizes the
fi rm's cost of capital
and thus maximizes
the value of
the fi rm.
"Railing against
managers for their
behavior is pointless;
shareholders
would behave the
same way if faced
with the same
risks and incentives.
MaruLl Suzukl lndla LlmlLed (MSlL) a subsldlary of Suzukl MoLor CorporaLlon (SMC) !apan ls Lhe leader
ln passenger cars (Cs) and mulLlpurpose vehlcles (Mvs) ln lndla accounLlng for nearly 30 per cenL of
Lhe LoLal lndusLry sales
ln 200910 Lhe Company sold 1018363 vehlcles 1hls comprlsed 870790 vehlcles ln Lhe domesLlc
markeL and 147373 vehlcles ln exporL markeLs CumulaLlvely lL has produced and sold over 8 mllllon
cars
1he LoLal lncome of Lhe Company for 200910 sLood aL 8s301198 mllllon MaruLl Suzukl has a sLrong
balance sheeL wlLh reserves and surplus of 8s 1169 bllllon and debL equlLy raLlo of 007 as on 31sL
March 2010
MSlL ls a publlc llmlLed company and ls llsLed on 8ombay SLock Lxchange LlmlLed and naLlonal SLock
Lxchange of lndla LlmlLed SMC ls Lhe ma[orlLy shareholder wlLh 3421 equlLy sLake ln Lhe Company
MSlL has Lwo manufacLurlng faclllLles ln Curgaon and Manesar Paryana lndla wlLh a comblned
manufacLurlng capaclLy of over 1 mllllon cars per annum ln Lerms of number of cars produced and sold
worldwlde Lhe Company ls Lhe largesL subsldlary of SMC !apan
Gurgaon |ant
Spread over an area of 20300 square meLers wlLh a capaclLy Lo produce over 300000 englnes per
annum Lhe Curgaon faclllLy houses Lhree fully lnLegraLed planLs havlng a comblned manufacLurlng

capaclLy of over 700000 vehlcles per annum and a sLaLeofLhearL kserles casLlng englne planL whlch
employs global manufacLurlng besL pracLlces Lo ensure hlgh quallLy sLandards
,anesar |ant
Manesar ls Lhe Companys laLesL car assembly planL whlch was sLarLed ln lebruary 2007 1hls planL has
a capaclLy Lo produce over 300000 unlLs per annum wlLh an addlLlonal capaclLy of 230000 cars per
annum Lhe operaLlon of whlch began ln 200910
k D 1est Course
ln 200910 700 acres of land ln 8ohLak Paryana have been procured by Lhe company for seLLlng up a
worldclass LesL course for 8 u
MSlL provldes lLs cusLomers wlLh onesLopshop experlence such as AuLomoblle llnance AuLomoblle
lnsurance MaruLl Cenulne arLs and Accessorles LxLended WarranLy and MaruLl CerLlfled preowned
cars 1he Company had 341 preowned car ouLleLs ln 198 clLles as on 31sL March 2010
MSlL has Lhe largesL sales and servlce neLwork amongsL car manufacLurers ln lndla lL had 802 sales
ouLleLs ln 333 clLles and 2740 servlce workshops ln 1333 clLles as on 31sL March 2010 1he servlce
neLwork of Lhe Company lncludes uealer Workshops MaruLl AuLhorlsed Servlce SLaLlons (MASSs)
MaruLl Servlce MasLers (MSM) and MaruLl Servlce Zones (MSZ)
LxporL sales of Lhe company Louched 147373 unlLs lLs hlghesL ever 1hls ls a 111 growLh over Lhe
prevlous years LoLal of 70023 unlLs Lurope has accounLed for over 73 of Lhe sales Cn a cumulaLlve
basls Lhe exporLs crossed 700000 unlLs CurrenLly Lhe company ls exporLlng Lo 98 counLrles ln Lurope
Asla LaLln Amerlca Afrlca and Cceanla
ln 200910 Lhe Company sold 1018363 vehlcles 1hls comprlsed 870790 vehlcles ln Lhe domesLlc
markeL and 147373 vehlcles ln exporL markeLs CumulaLlvely lL has produced and sold over 8 mllllon
cars

1he LoLal lncome of Lhe Company for 200910 sLood aL 8s 29623 bllllon MaruLl Suzukl has a sLrong
balance sheeL wlLh reserves and surplus of 8s 1169 bllllon and debL equlLy raLlo of 007 as on 31sL
March 2010
MSlL ls a publlc llmlLed company and SMC ls Lhe ma[orlLy shareholder wlLh 3421 equlLy sLake ln Lhe
Company

MaruLl Suzukl lndla LlmlLed (MSlL) Lhe largesL passenger car maker of lndla has been faclng a bad Llme
ln Lhe pasL few monLhs LosL markeL share labour problems aL Manesar producLlon planL and sLeadlly
lncreaslng compeLlLlon from oLher manufacLurers have been Lhe bane of Lhls glanL ln recenL Llmes
ln a bld Lo recapLure lLs losL glory Lhe company ls llnlng up a number of vehlcles Lo showcase aL Lhe
upcomlng 2012 new uelhl AuLo Lxpo AL Lhls evenL whlch wlll be Lhe blggesL ever ln Asla MaruLl Suzukl
wlll enLer a few new segmenLs and hope Lo ruffle a few feaLhers here and Lhere wlLh some new models


MaruLl Suzukl 600cc

Cne of Lhe mosL Lalked abouL launches ls Lhe LrLlga a compacL MulLlurpose vehlcle (Mv) 1he
company wlll exhlblL Lhls car for Lhe flrsL Llme aL Lhls hlgh proflle evenL and wlll cerLalnly be hoplng LhaL
all eyes wlll be aL lLs sLall 1hls car wlll be asslmllaLed wlLh a new k14 vv1 englne and wlll also be
avallable wlLh a 13 L dlesel uulS ulesel Super 1urbo Lnglne
AparL from Lhls Mv Lhe company wlll also foray lnLo Lhe SporLs uLlllLy vehlcle (Suv) segmenL wlLh lLs
flrsL model of Lhls Lype

MaruLl Wagnor

1hls sudden focus on passenger uLlllLy vehlcles sLems from Lhe poLenLlal of Lhe segmenL AL presenL Lhls
segmenL accounLs for 13 per cenL sales of Lhe LoLal cars sold ln Lhe lndlan auLo lndusLry 1he Mv
segmenL alone ls responslble for 9 per cenL sales of auLomoblles ln Lhe domesLlc markeL 1herefore Lhls
move by MaruLl Suzukl lnLo uncharLed LerrlLorles wlll help lL ln lncreaslng lLs boLLom llnes
As per Mayank areek Managlng LxecuLlve Cfflcer (MarkeLlng and Sales) MaruLl Suzukl As Lhe markeL
geLs more compeLlLlve we have Lo gear up for Lhe new dynamlcs We are Lhus showlng Lhe besL we can
offer 1he new models llke Lhe Suv Mv and Muv wlll prove Lo Lhe world LhaL we are fuLureready We
need Lo geL flrsLhand feedback for Lhls"
WlLh Lhe launch of Lhese passenger uLlllLy vehlcles Lhe blggesL small car maker of lndla wlll alm Lo
capLure a magnanlmous 30 per cenL share of Lhe domesLlc passenger car segmenL by 2013

MaruLl Suzukl alleLe

8uL lL seems LhaL uLlllLy vehlcles are noL Lhe only ones LhaL Lhls company ls looklng Lo unleash upon
lndlan roads 1he company may also be Lhlnklng abouL expandlng lLs small car porLfollo ln lndla by
exhlblLlng Lwo sub800 cc cars aL Lhe AuLo Lxpo ln !anuary 1hese Lwo cars called Lhe M8 Wagon and
aleLLe wlll be powered by Lhe same 660 cc englne Lhough Lhelr prlce wlll remaln hlgher Lhan LhaL of
Lhe 800 cc AlLo
1hough Lhe evenL wlll be used as a plaLform for showcaslng Lhese cars Lhe company has no lmmedlaLe
plans of launchlng Lhem ln lndla ln facL Lhe real purpose of Lhls move wlll be Lo assess Lhe response of
Lhe members of key demographlcs namely small car buyers abouL Lhese vehlcles 1hls concern sLems
from Lhe facL LhaL boLh cars look qulLe unconvenLlonal and wlll be prlced close Lo 8s 33 lacs Lo 8s 3
lacs qulLe hlgh conslderlng Lhelr englne capaclLy Powever Lhese have creaLed a nlche ln Lhe !apanese
markeL due Lo Lhelr spaclous lnLerlors peppy exLerlors and excellenL mlleage and Lhe company wlll wanL
Lhe same for lndla Loo
WlLh many producL unwrapplngs llned up by MaruLl Suzukl for Lhe upcomlng new uelhl AuLo Lxpo Lhe
company wlll hope Lo relnvlgoraLe sales and regaln losL consumers

1
Economic Value Added - A General Perspective
Asish K Bhattacharyya & B.V.Phani1
ABSTRACT

This paper explains the concept oI Economic Value Added (EVA) that is gaining popularity in India. The
paper examines whether EVA is a superior perIormance measure both Ior corporate reporting and Ior
internal governance. It relied on empirical studies in U.S.A. and other advance economies. It concluded
that though EVA does not provide additional inIormation to investors, it can be adapted as a corporate
philosophy Ior motivating and educating employees to diIIerentiate between value creating and value
destructing activities. This would lead to direct all eIIorts in creating shareholder value. The paper brings to
attention the dangerous trend oI reporting EVA casually that might mislead investors.
ntroduction
It is now well settled that the aim oI every business entity should be to maximize
shareholders wealth by enhancing the Iirm`s value and all the activities oI a Iirm should
be directed to achieve this objective. Various theories oI Iirm conceptualize a Iirm in
various ways and provide an understanding oI Iactors that contribute to the success oI a
Iirm.
The neo classical view oI the Iirm envisages a business entity as decision-maker based on
the supply and demand oI both input and output markets. Organizational theory view
addresses aspects oI a Iirm ignored by neoclassical economics. Disposing oI the notion oI
the Iirm as a singular decision-maker and recognizing the Iirm as a complex organization
encompassing multiple individuals, organization theory analyses the internal structure oI
the Iirm and the relationships between its constituent units and departments. The best
explanation that has revolutionized the way we look at the business entity is given by
Richard Coase who deIined the business entity Irom a 1ransaction cost view. It explains
the existence oI the Iirm with respect to the reduction in costs oI contractual
arrangements between the buyers and sellers oI productive resources. One can say that
the ability oI the Iirm to continue to be competitive Ior generating surplus depends on its
ability to reduce transaction costs between the buyers and sellers oI the productive
resources. The network view argues that the business entity once Iormed is not an
%

isolated instance but a part oI a social network, which can be deIined as a set oI nodes
2
(e.g., persons, organizations) linked by a set oI social relationships (e.g., Iriendship,
transIer oI Iunds, overlapping membership) oI a speciIied type (Laumann, Galaskiewicz,
and Marsden, 1978:458). In other words, an organization`s productivity is determined
less by its internal resources than by the set oI resources that it can mobilize through its
contacts. The more such contacts the Iirm has, the better it is plugged in` to the key task
and inIluence processes oI the industry, and the stronger is its strategic advantage
(Madhavan, Balaji, John, 1998). The gency view and Stewardship view, which are two
opposite views regarding the conIlict oI interests between the various agencies involved
in the management oI the Iirm. Agency theory argues that unless managers are monitored
constantly they act in selI-interest, which might be at variance with interests oI residual
claimants most importantly those oI shareholders. This variance can be reduced only
through the added costs oI monitoring or designing appropriate incentive structures
(Jensen and Meckling, 1976). On the other hand the stewardship theory argues that
managers interests lie in the well being oI the organization and they are at variance with
other stakeholders only when the managers` position is threatened due to environmental
threats like mergers, acquisitions and takeovers (Donaldson, 1990). 1he resource-based
view argues that the Iirm is bundle oI tangible and intangible resources and an
organization's success is dependent upon the eIIicient deployment oI these resources to
their best advantage (Grant 1991). 1he knowledge based view argues that the Iirm is a
institution that creates an environment under which multiple individuals can integrate
their specialist knowledge with low incentives designed to Ioster co-ordination between
individual specialists, thus avoiding the problems oI opportunism associated with high
incentives directly related to knowledge transactions (Grant, 1996).
%

The theories, taken together, explain that the success oI the business entity in maximizing
the Iirm-value depends on the eIIectiveness oI integrating interests oI the Iirms
stakeholders and managers by designing suitable incentive scheme; by improving
productivity oI resources in the Iace oI uncertainties, by eIIicient networking with other
institutions and social agents; and by reducing transaction costs. This paper examines the
1 Corresponding author
3
eIIectiveness oI Economic Value Added (EVA) in improving the perIormance oI the
Iirm as a whole and also as a measure oI perIormance.
Performance Measurement
Investors measure overall perIormance oI a Iirm as a whole to decide whether to invest in
the Iirm or to continue with the Iirm or to exit Irom it. In order to achieve goal
congruence, managers` compensation is oIten linked with the perIormance oI the
responsibility centers and also with Iirm-perIormance. ThereIore selection oI the right
measure is critical to the success oI a Iirm. To measure perIormance oI a Iirm we need a
simple method Ior correctly measuring value created/ enhanced by it in a given time
Irame. All the current metrics trade oII between the precision in measuring the value and
its cost oI measurement. In other words, each method takes into consideration the degree
oI complexities in quantiIying the underlying measure. The more complex is the process,
the more is the level oI subjectivity and cost in measuring the perIormance oI the Iirm.
There is a continuous endeavor to develop a single measure that captures the overall
perIormance, yet it is easy to calculate.
Each metric oI perIormance claims its superiority over others. PerIormance oI a Iirm is
usually measured with reIerence to its past record and the perIormance oI other Iirms
with comparable risk proIile. The various perIormance metrics currently in use are based

on the returns on investment generated by the business entity . ThereIore to reach a
meaningIul conclusion, returns generated by the Iirm in a particular year should be
compared with returns generated by assets with similar risk proIile (cross sectional
analysis). Similarly return on investment Ior the current period should be compared with
returns generated in past (time series analysis). A Iirm creates value only iI it is able to
generate return higher than its cost oI capital. Cost oI capital is the weighted average cost
oI equity and debt(WACC).
The perIormance oI a Iirm gets reIlected on its valuation by the capital market. Market
valuation reIlects investor`s perception about the current perIormance oI the Iirm and
also their expectation on its Iuture perIormance. They build their expectations on the
4
estimated growth oI the business in terms oI return on capital. This results in an
incongruence between current perIormance and the value oI the Iirm. Even iI the current
perIormance is better in relative terms, poor growth prospects adversely aIIects the value
oI the Iirm. ThereIore any metric oI perIormance, to be eIIective, should be able to not
only capture the current perIormance but also should be able to incorporate the direction
and magnitude oI Iuture growth. ThereIore the robustness oI a measure is borne out by
the degree oI correlation the particular metric has with respect to the market valuation.
PerIect correlation is impossible because as shown by empirical researchers,
Iundamentals oI a company cannot Iully explain its market capitalization, other Iactors
such as speculative activities, market sentiments and macro-economic Iactors inIluence
movement in share prices. However the superiority oI a perIormance metric over others
lies in providing better inIormation to investors.
Metrics oI perIormance have a very important and critical role not only in evaluating the
current perIormance oI a Iirm but also in achieving high perIormance and growth in the

Iuture. The metrics oI perIormance have a variety oI users, which include all the
stakeholders whose well being depends on the continued well being oI the Iirm. Principal
stakeholders are the equity holders, debt holders, management, and suppliers oI material
and services, employees and the end-users oI the products and services. Value creation
and maximization depends on the alignment oI the various conIlicting interests oI these
stakeholders towards a common goal. This means maximization oI the Iirm value without
jeopardizing the interests oI any oI the stakeholders. Any metric, which measures the
Iirm value without being biased towards any oI the stakeholders or particular class oI
participants, can be hailed as the true metric oI perIormance. However it is diIIicult, iI
not impossible, to develop such a metric.
Most oI the conventional perIormance measures directly relate to the current net income
oI a business entity with equity, total assets, net sales or similar surrogates oI inputs or
outputs. Examples oI such measures are return on equity (ROE), return on assets (ROA)
and operating proIit margin. Each oI these indices measure a diIIerent aspect oI
perIormance, ROE measures the perIormance Irom the perspective oI the equity holders,
5
ROA measures the asset productivity and operating proIit margin reIlects the margin
realized by the Iirm at the market place. The net income Iigure in itselI is dependent on
the operational eIIiciency, Iinancial leverage and the ability oI the entity to Iormulate
right strategy to earn adequate margin in the market place.
It is important to note that none oI these measures truly reIlect the complete picture by
themselves but have to be seen in conjunction with other metrics. These measures are
also plagued by the Iirm level inconsistencies in the accounting Iigures as well as the
inconsistencies in the valuation methods used by accountants in measuring assets,
liabilities and income oI the Iirm. Accounting valuation methods are in variance with the

methods that are being used to value individual projects and Iirms. The value oI an asset
or a Iirm, which is a collection oI assets, is computed by discounting Iuture stream oI
cash Ilows. The net present value (NPV) is the surplus that the investment is expected to
generate over the cost oI capital. Measures oI periodical perIormance oI a Iirm, which is
the collection oI assets in place, should Iollow the same underlying principles. Economic
value added (EVA)2 is a measure that captures the valuation principles.
ECONOMC VALUE ADDED - the concept
EVA is the most misunderstood term among the practitioners oI corporate Iinance. The
proponents oI EVA are presenting it as the wonder drug oI the millennium in overcoming
all corporate ills at one stroke and ultimately help in increasing the wealth oI the
shareholder, which is synonymous with the maximization oI the Iirm value. The
attractiveness oI the EVA lies in its use oI cash Ilow and cost oI capital that are
determinant oI the value oI the Iirm.
In the process, EVA is being bandied about with utmost impunity by all and sundry,
which includes the popular press. The academic world in its turn has come up with
various empirical studies which either supports the superiority oI EVA or questions the
claim oI its proponents. Currently the empirical evidence is split almost halI way.
6
EVA is nothing but a new version oI the age-old residual income concept recognized by
economists since the 1770's. Both EVA and residual income` concepts are based on the
principle that a Iirm creates wealth Ior its owners only iI it generates surplus over the cost
oI the total invested capital. So what is new? Perhaps EVA could bring back the lost
Iocus on economic surplus` Irom the current emphasis on accounting proIit. In a lighter
vein it can be said that in an era where commercial sponsorship is the ticket to the
popularity oI even the concept oI god, the concept oI residual income has not Iound a

good sponsor until Stern Stewart and Company has adopted it and relaunched it with a
brand new name oI EVA.
Technically speaking EVA is nothing but the residual income aIter Iactoring the cost oI
capital into net operating proIit aIter tax. But this is only the tip oI the iceberg as will be
seen in the next Iew sections. The paper examines EVA both as a measure oI overall
perIormance and a management philosophy that helps to improve the productivity oI
resources.
Mathematically:
' (adjusted AOP1 - cost of capital) x capital employed-------(I)
Or
' (Rate of return - cost of capital) x capital ---------(II)
Where;
Rate oI Return NOPAT/Capital
Capital total assets minus non interest bearing debt, at the beginning oI the year
Cost oI capital cost oI equity x proportion oI equity cost oI debt (1-tax rate) x
proportion oI debt in the capital.
The above cost oI capital is nothing but the weighted average cost oI capital (WACC)
2 EVA is the registered trademark oI Stern Stewart and Co.
7
Cost oI equity is normally estimated using capital asset pricing model (CAPM) that
estimates the expected return commensurate with the riskiness oI the assets.
II we deIine ROI as NOPAT/capital then the above equation can be rewritten as
' (ROI- W) x PI1 POY-----(III)
Capital being used in EVA calculation is not the book capital, capital is deIined as an
approximation oI the economic book value oI all cash invested in going-concern business

activities, capital is essentially a company`s net assets (total assets less non-interestbearing
current liabilities), but with three adjustments:
Marketable securities and construction in progress are subtracted.
The present value oI noncapitalized leases is added to net property, plant, and
equipment.
Certain equity equivalent reserves are added to assets:
Bad debt reserve is added to receivables.
LIFO reserve is added to inventories.
The cumulative amortization oI goodwill is added back to goodwill
R&D expense is capitalized as a long-term asset and smoothly depreciated over 5
years (a period chosen to approximate the economic liIe typical oI an investment in
R&D).
Cumulative unusual losses (gains) aIter taxes are considered to be a long-term
investment.
A Iirm can motivate its managers to direct their eIIort towards maximizing the value oI
the Iirm only by, Iirst measuring the Iirm value correctly and secondly by providing
incentives to managers to create value. Both are interdependent and they complement
each other. ThereIore this paper examines the EVA concept Irom two perspectives, EVA
as a perIormance measure and EVA as a corporate philosophy.
We shall examine EVA as a perIormance measure to assess whether it conveys any
additional inIormation to investors over conventional perIormance measures. In other
words, whether inIormation on EVA leads to better decision by investors.
8
Examining EVA as a corporate philosophy we intend to look at the eIIicacy oI EVA
when implemented at every level oI managerial decision making process to encourage

managers to deploy resources only on value enhancing activities and to align the interests
oI shareholders with managers. This involves two things, one is linking managerial
compensation package with EVA and second is to inculcate the culture oI evaluating
every action Irom the viewpoint that it should generate EVA. The ultimate outcome
should be enhancement in the Iirm-value measured by the capital market. When EVA is
used as a management philosophy, it results in the enhancement oI productivity by
continuously Iocusing on return vis-a-vis cost oI capital. However as market discounts
expected long term perIormance oI the Iirm, any compensation that motivates
enhancement oI short term EVA, may not maximize the Iirm value.
However with EVA culture, the Iirm as a whole Iocuses on the economic surplus and that
deIinitely improves value enhancement process. OI course, this can be achieved even by
implementing the other practices but the simplicity oI EVA in communicating the very
Iundamental principle, that generation oI surplus over cost oI capital can only enhance
the Iirm value, makes it a management technique superior to other planning and control
techniques. We shall examine the appropriateness oI this perception.
EVA AS A PERFORMANCE MEASURE
Proponents oI EVA argue that EVA is a superior measure as compared to other
perIormance measures on Iour counts:
it is nearer to the real cash Ilows oI the business entity;
it is easy to calculate and understand;
it has a higher correlation to the market value oI the Iirm and
its application to employee compensation leads to the alignment oI managerial
interests with those oI the shareholders, thus minimizing the supposedly
dysIunctional behavior oI the management.
The last two merits can be considered as a reIlection oI the Iirst two. II EVA truly

represents the real cash Ilows oI a business entity and it is easy to calculate and
9
understand, then it automatically Iollows that it should be closely related to the market
valuation and it should minimize the dysIunctional behavior oI the management when
used as an incentive measure. In other words, close relation to market valuation and
convergence oI managerial interests with shareholders interests is a vindication oI EVA
as a superior metric.
EVA as a perIormance measure looks into the eIIicacy oI EVA both as an absolute
measure in comparison with net income, residual income and similar measures as well as
a ratio in relation with perIormance measures like ROE, ROA and Operating ProIit
Margin, which are commonly used by both managers and equity analysts alike. These
measures are normally used internally by the management to evaluate employee
perIormance, incentive calculation and investment decisions and externally by equity
analysts to ascertain the perIormance and growth oI the Iirm. Along with these measures
valuation models like NPV, IRR, Payback period and Book rate oI return are used both
internally and externally by managers Ior investment decisions. The Iormer measures are
backward looking measures which take into account past and current perIormance and
Iacilitates prediction oI Iuture perIormance, whereas latter measures are more Iorward
looking and discount the expected Iuture cash Ilow streams associated with a given
investment or new investment to ascertain the economic viability oI the same.
' a superior performance measure?
First let us look into the claim oI EVA being superior than the conventional measures
such as ROI, ROE and ROA, which are based on the accounting Iigures. Most oI these
measures give us the rate oI return earned by the Iirm with respect to capital invested in
the Iirm. The most important limitation oI these measures are derived Irom limitations

inherent in the measurement oI accounting proIit. As per current accounting practices,
while historical-cost-based accounting measures are being used to carry most oI the
assets in the balance sheet, revenue and expenses (other than depreciation) are recognized
in the proIit and loss account at their current value. ThereIore accounting rate oI returns
do not reIlect the true return Irom an investment and tend to be biased downwards in the
10
initial years and upwards in the latter years. Similarly as noted by Malkelainen (Esa
Malkelainen 1998), distortion occurs basically due to the historical cost and straight line
depreciation schedule used by most businesses to value their assets. This leads to a bias
in these measures due to the composition oI assets oI a Iirm at any given point in time.
By composition he reIers to the current nature oI the assets, more current the assets are,
the accounting rate oI return is closer to the true rate oI return. This distortion will not be
signiIicant iI there is a continuous stream oI investments in assets i.e. the value oI the mix
oI assets is nearer to the current value oI the assets. But the probability, that at any point
oI time, a Iirm should have such a composition oI assets is rare, in most cases either the
assets are old or relatively new. This precludes these accounting measures Irom being
used to reach any meaningIul conclusion regarding the true perIormance oI the Iirm.
The other important limitation oI accounting measures is that they ignore the cost oI
equity and only consider the borrowing cost. As a result it ignores the risk inherent in the
project and Iails to highlight whether the return is commensurate with the risk oI the
underlying assets. This might result in selecting projects that produce attractive rate oI
return but destroys Iirm value because their cost oI capital is higher than the benchmark
return established by the management. On the other hand accounting measures encourage
managers to select projects that will improve the current rate oI return and to ignore
projects even iI their return is higher than their cost oI capital. Selection oI projects with
%

returns higher than the current rate oI return does not automatically increase
shareholders` wealth. Taking up only those projects, which provide returns that are
higher than the hurdle rate (cost oI capital) results in increasing the wealth oI the
shareholder. ThereIore use oI ROE, ROA or similar accounting measures as the
benchmark, might result in selection oI those projects that though provide rate oI return
higher than the current rate oI return destroys Iirm-value. Similarly use oI these measures
result in continuing with activities that destroys Iirm value until the rate oI return Ialls
below the benchmark rate oI return.
EVA proponents claim that because oI these imperIections, the accounting based
measures are not good proxies Ior value creation. Managerial compensation based on
11
these measures does not encourage value enhancement actions by managers. Value
enhancement and earnings are two diIIerent things and might be at cross-purposes
because short-term perIormance might be improved at the cost oI long term health oI the
Iirm. Activities involving enhancement oI current earnings may be short term in nature,
whereas any value enhancing activities should Iocus on long term well being oI the Iirm.
Avoidance oI discretionary costs improves current perIormance while destroying value oI
the Iirm. Managers` Iocus on short-term perIormance will increase as long as their
rewards are tied to the current perIormance over long-term value enhancement
(Damodaran 1998, David Young 1999).
The question arises whether EVA is an improvement over conventional measures and
serves the purpose oI motivating managers to pay attention to shareholders value even iI
that results in compromising current perIormance. The answer may be negative because
all the above limitations are also associated with EVA. As shown in equation III the
calculation oI EVA entails the usage oI a accounting rate oI return, the diIIerence lies
%

only in the Iact that the cost oI equity is also Iactored in to arrive at the residual income
Iigure. Though incorporation oI the cost oI equity capital is the virtue oI EVA, because it
measures economic surplus, it does not remove the limitations oI the accounting proIit
that Iorms the basis Ior computing EVA. Moreover the virtue might not be realized in
practice since it is not easy to calculate the cost oI equity. Market returns cannot be used
as a proxy Ior cost oI equity that supports assets in place because market discounts the
expectations. Similarly it is diIIicult to use CAPM in measuring cost oI equity because it
is diIIicult to measure risk-Iree-rate oI return, beta and market premium. DiIIiculties get
compounded in an economic environment like India, where interest rates Iluctuate
Irequently, the capital market is volatile and the regulators are yet to have a complete grip
on the capital market to enhance its eIIiciency. Empirical studies show that the volatility
in the Indian capital markets, like capital markets in other developing economies, is
higher than capital markets in developed economies (Tushar Waghmare 2000). Similarly
studies show that beta Ior companies listed in Indian capital markets is not stable (Sanyal,
Guha Roy and Sanyal 2000). It is diIIicult to ascertain the market premium because oI
the short history oI the Indian capital market, which has become active only in the last
12
decade and also because oI its high volatility. ThereIore even iI Ior the sake oI argument
it can be said that the potential oI EVA as a measure oI perIormance can be realized Iully
in an advanced economy, the argument that EVA is a better measure is not tenable in the
Indian context.
In India EVA is being used with impunity. A case at point is the study published by
Economic times (11th December 2000)3 , on corporate perIormance. While computing
EVA it used a Ilat rate oI 13 percent as the cost oI capital oI all the enterprises included
in the study. The study explains that an average 13 percent interest Ior both the years

covered by the study is used as it is almost equal to the prime-lending rate oI the
commercial bank and Iinancial institution. It is a basic principle oI economics that
higher the risk higher is the expected return`. By estimating WACC at 13 this basic
principle is violated. It may be argued that cost oI debt should be taken post-tax and
thereIore eIIective cost oI equity incorporated in the calculation is higher than 13 percent.
Even iI this argument is accepted the computation cannot be deIended because the cost oI
capital is estimated without using any accepted economic model. Moreover by using a
Ilat rate, variation in risk proIiles oI Iirms have been ignored. This shows both the
popularity oI EVA in India and diIIiculties in measuring the same. The study has also
ignored adjustments in capital and operating income suggested by proponents oI EVA
Is ' simple to understand and calculate ?
The proponents oI EVA propose certain adjustments in accounting Iigures to calculate a
proxy Ior economic capital. The objectives oI such adjustments are:
1) to measure capital at closer to the current value;
2) to include all investments that are treated as period costs by accountants (such as
R&D expenditure) and
3) to bring EVA closer to the real cash Ilows oI the company.
The Stern Stewart & Co. which is the Iront runner in eulogizing the utility oI EVA,
recommends nearly 160 adjustments to the accounting Iigures Ior a realistic estimate oI
13
EVA. These adjustments truly complicate the calculation oI EVA. Most enterprises do
not maintain in-depth data required Ior these adjustments and even iI it is maintained it is
not accessible to outsiders and it Iurther complicates the computation. For the insiders
who have access to the data these adjustments make the calculation too complicated to
necessitate the hiring oI a consultant. This involves additional costs, which are oIten not

insigniIicant. Taking this into account most oI the EVA proponents recommend that these
adjustments have to be scaled down based on the relevance and incremental inIormation
that they oIIer.
Stewart argues that distortions in GAAP-based accounting should be corrected to the
extent that it is practical to do so, which means that adjustments should be made only iI:
1) the amounts are significant;
2) managers can influence the outcome of the item being adjusted;
3) the required information is readily available; and
4) non-finance professionals can understand them. (Stewart 1991).
Thus Out oI these 160 odd adjustments around 15 adjustments are considered crucial by
die hard EVA proponents but in recent years this requirement has been scaled down
signiIicantly by many consultants to around Iive to six adjustments.
These adjustments are aimed at :
1) producing an EVA figure that is closer to cash flows, and less subject to the
distortions of accrual accounting;
2) removing the arbitrary distinction between investments in tangible assets, which
are capitalized, and intangible assets, which tend to be written off as incurred;
3) prevent the amortization, or write-off, of goodwill;
4) eliminate the use of successful efforts accounting;
5) bring off-balance sheet debt into the balance sheet; and
6) correct biases caused by accounting depreciation. ( S David Young,1999)
Although many adjustments to GAAP-based accounting proIit are possible, the Iollowing
are the most commonly proposed:
3 see annexure 1
14

. Aon-recurring gains and losses.
2. Research and development expenses.
3. eferred taxes.
4. Provisions for warranties and bad debts.
5. IFO reserves.
. Coodwill.
7. epreciation.
8. Operating leases.
Studies that endeavored to Iind out the beneIits oI these adjustments concluded that they
are largely irrelevant and result in only incremental addition to the inIormation produced
by EVA, even iI adjustments are tailored to the nature oI the business oI the company.
The main argument put Iorward is that even though the logic behind these adjustments is
impeccable, whether these adjustments help in countering any dysIunctional or suboptimal
behavior oI the managerial staII is suspect. It is argued that these adjustments are
more crucial Ior the external user. But Ior most Iirms, adjusted EVA oIIers Iew
advantages over unadjusted EVA. Moreover it carries the costs oI increased complexity
and any other costs that arise when proIit measures deviate Irom GAAP. In short, the
residual income measure Iirst proposed by AlIred Sloan seventy-Iive years ago is likely
to oIIer the same advantages as today's highly advertised EVA. (S.David Young 1999).
As mentioned above the veracity oI EVA is dependant on the various adjustments
proposed to minimize the accounting biases, which in itselI is a complicated process.
Other than this the increase in the number oI adjustments increase the subjectivity
involved in measuring EVA(Damodaran 1998). It is very diIIicult to and almost
impossible to quantiIy all the value enhancement activities oI a Iirm without involving lot
oI subjective estimates and thereIore even with the various accounting adjustments

proposed to remove the accounting biases in the estimation, EVA computation tends to
increase the subjectivity in its estimate.
15
Though the idea oI EVA is simple and theoretically elegant, its implementation is
diIIicult and oIten takes away much oI the potential beneIits.
Is ' a better signal to the capital market ?
Capital market theories have established cash Ilow based valuation models that are
extensively used by analysts Ior valuation oI Iirms and equity. It is highly improbable
that a single number can capture all the inputs required by those models. Aggregation
results in loss oI inIormation. ThereIore accounting standard setters and regulators, all
over the globe, require Iirms to be transparent and disclose inIormation that Iinancial
statements Iail to capture, either as a part oI Iinancial statements or by way oI a separate
report. Analysts use those inIormation along with inIormation collected Irom other
sources, to value Iirms. However they oIten use a single Iigure, like ROI, as a signal Ior
good and bad news`. EVA should be considered a superior substitute oI ROI or similar
measures only iI it provides a better signal.
Independent researchers concluded that even though EVA is correlated to stock returns, it
is not much greater than the correlation between accounting proIit and stock return.
ThereIore though EVA might be incrementally better over other measures, it does not
really provide any signiIicant inIormational advantage. It is pertinent to note that this
conclusion is drawn by empirical studies that used the database created and maintained
by Stern Stewart & Co (Dodd & Chen 1997; Biddle, Bowen & Wallace 1999). ThereIore
chances oI bias due to incomplete data are almost eliminated. Empirical studies in other
countries have also conIirmed that EVA does not provide better signal to the capital
market. II the empirical studies globally do not provide evidence to support the argument

that EVA provides a better signal to the capital market, it may be easily concluded that
results oI similar studies will not be diIIerent Ior companies listed in the Indian stock
exchanges because Indian capital markets are less eIIicient as compared to markets in
advanced economies. In India it is even more diIIicult to have a database Ior conducting
such studies and thereIore even iI some studies show results diIIerent Irom the
conclusions oI global studies, the same should be viewed with utmost caution.
16
EVA as a Corporate Philosophy
Though EVA may not have better inIormational value to capital markets, it can be very
useIul in improving productivity oI a Iirm, iI adapted as a corporate philosophy.
Productivity should be measured in terms oI creation oI wealth Ior shareholders. An
appropriate corporate philosophy should result in goal congruence and should channel
all eIIorts oI the management and employees towards a pre-determined goal and
strategies oI the Iirm. A Iirm can enhance its value only iI it is able to achieve optimal
productivity, in terms oI value over a long period oI time. Over the years management
experts and consultants have proposed many tools and techniques Ior improving
productivity. Firms have tried these tools with varied degree oI success. Many oI the
success stories in relation with implementation oI those tools and techniques have taken
their place in the annals oI history.
Some oI the most notable oI these are Management InIormation Systems (MIS), Business
Process Reengineering (BPR), Enterprise Resource Planning (ERP), and Brand Valuation
in capital budgeting . Though all these tools have diIIerent perspectives, they aim at
improving the productivity in physical terms and ignore the concept oI value. They
Iacilitate increase in the productivity and eIIiciency oI the Iirm that ultimately contributes
to the bottom-line oI the Iirm but increased bottom-line is no guarantee Ior increase in the

shareholders value.
Almost all the tools and techniques are used to reorient the employees` perception oI
managing value drivers` and that culminates into empowerment oI employees cutting
across the hierarchical levels. All these tools aims at improving productivity by reducing
redundancies in the value chain`, BPR by simpliIying existing processes and eliminating
non value added activities, MIS by improving the quality and Ilow oI inIormation and
ERP by ensuring eIIicient allocation and utilization oI enterprise resources.
The success oI these tools reIlects in reduced costs Ior delivering products or services to
customers, though it may not always result in increasing shareholder value. These tools
Iail to distinguish between activities that create value and those that destroy value
17
because they do not measure economic surplus` being generated by diIIerent activities.
Moreover successIul implementation oI these tools and techniques involve extensive
retraining oI employees and constant monitoring oI perIormance. In most cases the
success or Iailure oI these techniques depends on the eIIectiveness oI communication oI
the philosophy and process oI implementation to employees at all levels. The success oI
these tools to a great extent depends on how well the Iirm is able to resolve the problem
oI resistance to change and the ability oI the management to earn commitment oI
employees, to the implementation oI these techniques. Given this scenario the
implementation oI these management tools across the Iirm is a long drawn process and
the possibility oI success is not very high.
In contrast EVA is an easy to understand concept. EVA, as a corporate philosophy,
entails using oI EVA at every decision level in the organization. In Iact EVA should be
adapted as a culture within the organization rather than as a project. EVA when used as a
corporate philosophy does not require precise estimation, thereIore hurdles in estimating

EVA does not come in the way oI building the EVA culture in an organization. A Iirm
can roughly estimate its WACC a hurdle rate that is being used by Iirms in capital
budgeting decisions. ThereIore it is not diIIicult Ior employees to use EVA Ior decisionmaking
including operational decisions.
There are more than 300 corporates, world wide that have adapted EVA as a corporate
philosophy. Many oI these organizations are successIul multinationals like Coca-Cola,
Bausch & Lomb, Briggs & Stratton and Herman Miller. Some oI the state owned
enterprises in U.S.A. including the U.S. Postal service that has the largest civilian labor
Iorce in the world, have adapted EVA culture to improve eIIiciency in services and to
motivate the employees.
The advantage oI EVA over other similar tools is that it improves business literacy
because oI easy understandability and conceptual clarity. The one component that sets it
apart over conventional measures is its consideration oI the cost oI capital and this is the
one component, which should be understood by everyone involved in operations.
18
Business literacy is the eIIort oI management to convey to all the employees the Iact that
Ior any activity to be value enhancing the return generated should be over and above the
cost oI capital employed Ior that activity. This small shiIt in the outlook oI the employees
immediately raises the threshold limit oI the returns generated to create value. Usually
employees do not look at their actions Irom this perspective and thereIore there is a need
to continuously highlight the concept.
As explained earlier compensation methods based on EVA work better in achieving the
objective oI goal congruence and minimize the agency cost. Use oI EVA improves
internal corporate governance` in the sense that it motivates manager to get rid oI value
destructive activities and to invest only in those projects that are expected to enhance

shareholder value.
Ideally a management control system should motivate managers Ior selI control` rather
than managers are being controlled because human beings have general resistance to
controls. Linking compensation with EVA helps employees in conducting a selIexamination
oI every action taken by them to ensure that it enhances EVA oI the Iirm.
Care should be taken to tie compensation to the enhancement oI long term EVA rather
than short term EVA. As discussed earlier, managers do have scope to enhance the short
term EVA at the cost oI long term value creation by rejecting good investment
opportunities that have long gestation period or, avoiding discretionary costs or by
targeting a capital structure that might reduce the WACC in the short run while
enhancing the Iinancial risk in the long run. One way to counter this limitation is to deIer
payment oI a part oI incentives.
Empirical evidence supports the above observations. Empirical studies concluded that
EVA, when used as an incentive compensation measure, tends to improve the value oI
the Iirm by inducing managers towards value creating activities (Biddle, Bowen and
Wallace 1999). Using EVA or Residual Income measures Ior incentive compensation
leads to:
the improvement in operating eIIiciency by increasing asset turnover;
19
disposal oI selected assets and reduce new investments (the assumption is that these
assets have Iailed in earning adequate returns when compared to the overall cost oI
capital) and
more share repurchases (consistent with distributing under perIorming capital to
shareholders).
It may be concluded that though EVA Iails to provide additional inIormation to the
%

capital market, it can be used to improve the internal governance oI a Iirm.
The ndian Context
India has Iound supporters Ior EVA. It has already earned Iavor with journalists and
leaders in corporate reporting. However most oI them do not calculate EVA rigorously,
rather they take casual approach in calculating and reporting EVA. We have examined a
study by Economic Times, the most popular business daily in India and the annual report
oI InIosys Technologies limited that has won prestigious best presented annual report`
being awarded by the Institute oI Chartered Accountants oI India (ICAI) Ior Iive years in
this context.
The study published by Economic Times neither adjusted book capital to bring it closer
to economic capital nor used rigorous model to compute the cost oI equity. Perhaps the
short cut was adopted by the study to circumvent diIIiculties in estimating equity and
converting book capital into economic capital.
InIosys Technologies Limited known Ior its transparency in Iinancial statements, may be
considered a pioneer in reporting EVA in annual report. A perusal oI the EVA statement
published by InIosys4 in its annual report Ior the year 99-2000 reveals certain important
shortcomings.
InIosys has used book capital Ior computing EVA. It has not carried out any adjustment
Ior converting book capital into economic capital. This distortion may not be material
because in year 2000 it spent less than 1 percent oI total revenue in research and
20
development expenditure. Similarly it has not adjusted the net income Iigure to bring it
closer to the amount oI cash Ilow generated by the Iirm. According to proponents oI
EVA, these adjustments are important in computing EVA.
The cost oI equity used by InIosys is also questionable. It has used CAPM Ior estimating
%

the cost oI equity. It has a uniIorm beta variant oI 1.48, The average beta variants Ior
soItware stocks in US Ior all the Iour years (1997-2000) covered in the statement. It
appears that the beta variant has not been adjusted Ior sovereign risks and other Iactors.
This might have distorted cost oI equity. Moreover, it is not clear why a uniIorm beta
should be used Ior all the years. It is now well established that beta does not remain
constant over a long period, thereIore it is appropriate to compute beta separately Ior
each year. Similarly it has used market premium oI 8 percent, 9 percent, 10 percent and
10 percent Ior all the years 2000, 1999, 1998 and 1997 respectively. It appears that
market premium has been estimated on certain assumptions best known to the preparers
oI the EVA statement. It is diIIicult to estimate the market premium in volatile markets,
thereIore in computing EVA there is no option but to estimate market premium based on
certain assumptions. This makes EVA computation highly subjective thereIore, in the
absence oI disclosures oI those assumptions, the inIormative value oI the EVA reduces
very signiIicantly and it carries only ornamental value to decorate the annual report.
The EVA statement also shows a reduction in the cost oI equity Irom 27.97 percent in
1997 to 22.29 percent in 2000. This reduction is explained by the reduction in risk Iree
debt cost Irom 13.6 percent in 1997 to 10.45 percent in 2000 and the reduction in market
premium Irom 10 percent in 1997 to 8 percent in 2000. These reductions do not reIlect
the market reality because according to one calculation return on 91 day T-bills increased
Irom 6.79 percent Ior Iiscal year 1997-98 to 9 percent in Iiscal year 1999-2000. II we use
the cost oI capital oI 27.97 Ior 1999 and 2000, EVA Ior the year 2000 comes to
Rs.8907.70 lakhs as against Rs.12,905.67 lakhs and Ior the year 1999 it comes to Rs.
6427.25 lakhs as against Rs. 7077.60 lakhs reported in the EVA statements. Though it
4 See annexure 2
21

may not be concluded that InIosys has overstated EVA in its report, it may not be
inappropriate to conclude that EVA Iigures reported in the annual report are incorrect.
The above analysis shows the diIIiculties in computing EVA and also that companies are
unable to resolve those diIIiculties. However the popularity oI EVA has tempted the
companies to report EVA as a public relations measure, even iI such reporting is
misleading.
Indian companies have started using EVA Ior improving internal governance. The Tata
Iron and Steel Company (TISCO) is using EVA to measure perIormance oI its mines and
other business segments. Managers oI the company Iind the measure quite useIul and are
highly enthused by the use oI this measure. It is expected that EVA will gain popularity
more as a management planning and control tool.
Conclusion
The concept oI EVA is based on the sound economic principle that Iirm value increases
only iI it is able to generate surplus over its cost oI capital and thereIore it is based on
strong theoretical Ioundation. However its calculation involves signiIicant subjectivity
and this reduces its inIormative value. Moreover it Iails to provide better signals to the
capital market as compared to conventional accounting measures like ROI, however hard
selling oI EVA has contributed positively in highlighting the Iundamental economic
principle, long Iorgotten by managers. In India companies are using EVA internally as a
perIormance measure Ior improving productivity that would lead to enhancement oI
shareholder value. However a dangerous trend has also set in, to use EVA casually Ior
external reporting. This trend should be stalled as such reporting might mislead users oI
those reports.
22
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23
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24
ANNEXURE 1
Economic Times Study On Corporate Performance Monday 11 December 2000
TOP 100 NDAN MANUFACTURNG SECTOR
COMPANY 99-2000 98-99 Rise/Fall
(Rs crore)

RELIANCE INDUSTRIES 639.27 -203.15 842.42
BAJAJ AUTO LTD. 382.73 384.16 -1.43 -0.37
HINDALCO INNDUSTRIES 356.14 288.31 67.83 23.53
HERO HONDA MOTORS 251.19 152.32 98.87 64.91
WIPRO 229.03 72.88 156.15 214.26
INFOSYS TECH 225.07 79.59 145.48 182.79
GLOBAL TELE SYSTEMS 168.34 44.66 123.68 276.94
PUNJAB TRACTORS 144.08 140.13 3.95 2.82
MAHINDRA & MAHINDRA 137.92 70.99 66.93 94.28
MRF 128.97 155.61 -26.64 -17.12
NIIT 118.86 92.50 26.36 28.50
SATYAM COMPUTER 107.04 52.49 54.55 103.92
RANBAXY LABARATORIES 103.42 31.06 72.36 232.97
ASIAN PAINTS 101.82 66.91 34.91 52.17
CIPLA 101.32 99.18 2.14 2.16
GUJARAT POWER GEN 87.44 34.16 53.28 155.97
ESCORTS 84.60 41.36 43.24 104.55
TVS SUZUKI 79.44 74.57 4.87 6.53
BPL 76.49 72.79 3.70 5.08
KIRLOSKAR OIL ENGINES 74.84 15.76 59.08 374.87
NAGARJUNA FERTILISERS 73.31 84.91 -11.60 -13.66
BSES 72.18 66.58 5.60 8.41
AUROBINDO PHARMA 71.00 50.77 20.23 39.85
MUKAND 70.24 5.76 64.48 1119.44
INDO GULF CORPORATION 67.78 -74.19
GODREJ SOAPS 62.74 -41.44
APPOLLO TYRES 61.87 43.28 18.59 42.95
NIRMA 61.76 82.60 -20.84 -25.23
TATA TEA 61.33 134.45 -73.12 -54.38
HCL INFO SYSTEMS 57.60 31.15 26.45 84.91
BRITTANIA INDUSTRIES 55.25 38.27 16.98 44.37

DABUR INDIA 51.76 28.07 23.69 84.40
GUJ AMBUJA CEMENTS 49.83 8.28 41.55 501.81
TRIVENI ENGINEERING 48.75 9.64 39.11 405.71
TRACTORS AND FARM EQUIP 48.44 69.07 -20.63 -29.87
CEAT 46.19 58.90 -12.71 -21.58
SRF 42.19 32.36 9.83 30.38
RALLIS INDIA 39.53 43.32 -3.79 -8.75
KEC INTERNATIONAL 39.39 40.13 -0.74 -1.84
MIRC ELECTRONICS 38.42 24.53 13.89 56.62
VIDEOCON APPLIANCES 38.09 19.99 18.10 90.55
SAMTEL COLOR 36.59 -5.79
DUNCANS INDUSTRIES 36.32 69.07 -32.75 -47.42
TATA CHEMICALS 32.04 89.31 -57.27 -64.12
MAHAVIR SPINNING 30.15 30.90 -0.75 -2.43
EXIDE INDUSTRIES 28.96 18.67 10.29 55.12
SPIC 26.67 15.62 11.05 70.74
SUASHISH DIAMONDS 25.69 25.89 -0.20 -0.77
PAINTS LIMITED 24.29 18.33 5.96 32.52
MODI RUBBER 23.92 17.03 6.89 40.46
GODREJ AND BOYCE 22.15 0.33 21.82 6612.12
EID PARRY 22.07 5.02 17.05 339.64
MCDOWELL & CO 21.48 18.71 2.77 14.80
FINOLEX INDUSTRIES 15.01 -51.95
25
SURYA ROSHNI 14.94 5.49 9.45 172.13
TITAN INDUSTRIES 13.94 13.62 0.32 2.35
RUCHI SOYA 13.71 12.08 1.63 13.49
IVP 13.19 19.23 -6.04 -31.41
BUSHAN STEEL 9.22 -0.20
VOLTAS 5.84 21.75 -15.91 -73.15
TUBE INVESTMENTS 5.69 -23.41

VAM ORGANIC CHEM 4.29 17.81 -13.52 -75.91
TATA SSL 1.88 -44.17
EVEREADY INDUSTRIES 0.57 38.55 -37.98 -98.52
SURAT ELECTRICITY 0.19 -4.05
JAIPRAKASH INDUSTRIES -1.90 -23.72
STERLITE INDUSTRIES -2.27 -70.35
INDIAN ALUMINIUM -2.52 -9.35
CENTURY ENKA -2.63 -20.29
LML -3.99 26.31
MADRAS CEMENTS -4.76 12.99
KESORAM INC\DUSTRIES -5.72 -12.43
JINDAL IRON AND STEEL -6.76 -37.32
EICHER -8.34 10.27
JK INDUSTRIES -9.25 -19.12
UNITED PHOSPHORUS -9.82 -12.44
BOMBAY DYEING -13.11 -63.77
USHA BELTRON -16.94 4.42
CENTURY TEXTILES -17.57 -156.47
BAJAJ TEMPO -19.33 -31.51
WOCKHARDT -20.70 -30.48
ZUARI INDUSTRIES -29.31 -42.99
HIMACHAL FUTURISTIC -30.51 -27.78
BIRLA CORPORATION -34.12 -49.66
CHAMBAL FERTILISERS -35.90 -19.34
JINDAL POLYESTER -37.32 -8.40
HINDUSTAN MOTORS -41.57 -27.42
ORIENT PAPER -41.85 -70.27
GREAVES -43.00 38.99
RAYMOND -43.65 11.43
LARSEN AND TUBRO -47.68 21.21
CESC -54.16 -231.63

VIDEOCON INERNATIONAL -70.68 -115.39
TATA ENGINEERING -81.54 -148.97
GRASIM INDUSTRIES -92.68 -161.68
USHA ISPAT -115.21 -100.36
ACC -140.20 -14.46
TATA STEEL -185.82 -339.04
SR STEEL -658.23 -756.39
MANGALORE REFINERY -738.57 -319.80
26
TOP 100 MULTNATONAL COMPANES OPERATNG N NDA
HINDUSTAN LEVER 1132.16 882.85 249.31 28.24
ITC 1035.33 724.82 310.51 42.84
CASTROL INDIA 209.41 163.28 46.13 28.25
NESTLE INDIA 134.16 108.06 26.10 24.15
NOVARTIS INDIA 121.19 85.09 36.10 42.43
MOTOR INDUSTRIES 107.97 70.14 37.83 53.93
SMITH LINE BEECHAM CON HEALTH 104.77 90.81 13.96 15.37
CUMMINS INDIA 80.23 56.06 24.17 43.11
GLAXO INDIA 66.94 84.71 -17.77 -20.98
SHAW WALLACE 66.46 53.25 13.21 24.81
KNOLL PHARMACEUTICALS 62.44 18.37 44.07 239.90
COLGATE PALMOLIVE 50.20 37.10 13.10 35.31
PROCTOR & GAMBLE 47.78 32.24 15.54 48.20
INGERSOLL RAND 47.48 52.81 -5.33 -10.09
I-FLEX SOLUTIONS 44.53 34.27 10.26 29.94
PFIZER 42.81 16.74 26.07 155.73
RHONE - POULENC 42.80 28.46 14.34 50.39
JOHNSON AND JOHNSON 41.08 31.84 9.24 29.02
ICI INDIA 34.85 54.67 -19.82 -36.25
CADBURY INDIA 33.96 18.65 15.31 82.09
SEIMENS 33.41 -42.12
%

BURROUGHS WELCOME 32.94 23.42 9.52 40.65
HOECHST MARION ROUSSEL 31.99 18.95 13.04 68.81
BATA INDIA 30.42 12.58 17.84 141.81
WYETH LEDERIE 27.47 22.74 4.73 20.80
PHILIPHS INDIA 26.28 17.64 8.64 48.98
GERMAN REMEDIES 26.19 26.10 0.09 0.34
VIDIA 25.75 23.97 1.78 7.43
HUGHES SOFTWARE 24.44 8.31 16.13 194.10
POLARIS SOFTWARE 24.30 10.06 14.24 141.55
BAYER 23.68 27.72 -4.04 -14.57
INDIAN SHAVING PRODUCTS 22.77 14.31 8.46 59.12
GVK INDUSTRIES 22.10 32.83 -10.73 -32.68
VST INDUSTRIES 20.01 -83.17
SEIMENS INFORMATION SYS 18.80 17.04 1.76 10.33
PARK DAVIS 18.36 10.41 7.95 76.37
E MERCK 17.48 27.07 -9.59 -35.43
CLARIANT 17.20 16.94 0.26 1.53
KRUPP INDUSTRIES 17.18 19.27 -2.09 -10.85
DIGITAL EQUIPMENT 16.82 23.56 -6.74 -28.61
CIBA SPECIALITY CHEM 16.49 11.17 5.32 47.63
SANDVIK ASIA 16.30 -5.26
WARTSILA NSD 15.45 8.13 7.32 90.04
GOOD YEAR INDIA 14.82 18.62 -3.80 -20.41
HONDA SIEL POWER 14.36 17.35 -2.99 -17.23
BASF 14.16 6.31 7.85 124.41
ASTRA-IDL 14.05 11.15 2.90 26.01
SMITHKLINE BEECHAM PHARMA 13.92 30.97 -17.05 -55.05
GOODRICKE GROUP 12.99 32.91 -19.92 -60.53
SILVER LINE TECHNOLOGIES 12.60 25.56 -12.96 -50.70
STRIDES ARCOLAB 12.25 2.44 9.81 402.05
ASEA BROWN BOVERI 11.62 -0.26
%

INFAR 11.28 7.92 3.36 42.42
COLOR CHEM 10.91 -12.35
GULF OIL INDIA 10.82 11.11 -0.29 -2.61
KSB PUMPS 10.13 12.46 -2.33 -18.70
SEIMENS PUBLIC CUMMU 10.02 -13.89
TIMKEN INIDA 9.20 -1.58
27
DUPHAR-INTERFRAN 9.14 1.19 7.95 668.07
MONSANTO INDIA 8.90 10.17 -1.27 -12.49
ALFA LAVEL 8.87 -4.92
VESUVIUS INDIA 8.50 7.10 1.40 19.72
ASHOK LEYLAND 7.27 -50.75
RECKITT AND COLEMAN 6.25 26.69 -20.44 -76.58
ATLAS COPCO 6.25 9.63 -3.38 -35.10
COATES INDIA 5.86 3.43 2.43 70.85
ZENSAR TECHNOLOGIES 5.69 13.55 -7.86 -58.01
FAG BEARINGS 5.16 3.71 1.45 39.08
ITW SIGNODE 4.73 -34.83
GRINDWELL NORTON 4.72 1.17 3.55 303.42
SKF BEARINGS 4.52 -62.36
IDL INDUSTRIES 3.93 3.24 0.69 21.30
YOKOGAWA BLUESTAR 3.91 0.89 3.02 339.33
FALCON TYRES 3.60 5.66 -2.06 -36.40
MATSUSHITA LAKHANPAL 3.14 5.11 -1.97 -38.55
VANAVIL DYES AND CHEM 2.31 3.45 -1.14 -33.04
CHICAGO PNEUMATIC 2.27 1.63 0.64 39.26
GEOFFREY MANNERS 2.04 1.30 0.74 56.92
CARRIER AIRCON 1.47 24.33 -22.86 -93.96
ASSAM CO 1.38 5.79 -4.41 -76.17
VASHISTI DETERGENTS 0.95 0.55 0.40 72.73
ELECTRIC LAMP MFRS -0.17 1.94

CABOT INDIA -0.28 3.44
GKN DRIVE SHAFTS -0.71 -3.71
ABBOT LABARATORIES -0.83 0.93
MATSUSHITA TELEVISION -2.64 -6.59
AVERY INDIA -3.49 -0.92
BAUSCH AND LOMB -3.91 7.46
ETERNIT EVEREST -5.58 -9.51
DENSO INDIA -7.10 -3.07
WIMCO -11.91 -12.98
ION EXCHANGE -11.95 -5.14
HENKEL SPIC -12.40 -7.50
SAURASHTRA CEMENT -22.36 -2.55
WHIRLPOOL OF INDIA -23.16 -90.30
ISPAT ALLOYS -29.00 -16.23
MADHURA COATS -31.73 -1.67
GONTERMANN PEIPERS -51.10 -43.92
ITC BADRACHALAM -58.84 -124.85
ISPAT INDUSTRIES -642.46 -532.87
28
ANNEXURE 2
EVA Statement Of nfosys As Published n The Annual Report 1999-2000
Economic Value Added (EVA) Statement
Economic Value-Added, Analysis
Year ended march 31, 2000 1999 1998 1997
Average Capital Employed (Rs. In lakhs) 70386.70 24541.61 14289.67 9846.75
Average debt/total capital () 2.16
Beta variant 1.48 1.48 1.48 1.48
Risk-Iree debt cost () 10.45 12.00 12.15 13.60
Market Premium 8.00 9.00 10.00 10.00
Cost oI equity () 22.29 25.32 26.95 28.40
Cost oI Debt (post tax) () NA NA NA 7.70

Weighted average cost oI capital (WACC) () 22.29 25.32 26.95 27.97
PAT as a percentage oI average capital employed () 40.63 54.16 42.24 33.91
Economic Value Added (EVA)
operating proIit
(PBT excluding extraordinary income) 32564.86 15585.54 6586.33 3893.03
Less: tax 3970.00 2294.00 550.00 554.00
Less:cost oI capital 15689.19 6213.94 3851.07 2754.34
Economic value-added 12905.67 7077.60 2185.26 584.69
Enterprise value
Market value oI equity 593317.00 967279.95 296342.20 73104.17
Less:cash and cash equivalents 50837.38 41665.91 5114.20 2877.82
Add: debt
Enterprise value 5882979.62 925614.04 291228.00 70226.35
Ratios
EVA as a percentage oI average capital employed () 18.34 28.84 15.29 5.94
Enterprise value/average capital employed 83.58 37.72 20.38 7.13
Notes
the cost oI equity is calculated by using the Iollowing Iormula:
return on risk-free investment + expected risk premium on equity investment/adjusted for average beta
variant for software stocks in the US
1he flgures above are based on lndlan CAA flnanclal sLaLemenLs

ln presenL scenarlo Lhe nonom|n Va|ue Added(VA) ls becomlng popular


Lconomlc value Added deflnlLlon
VA (nonom|n Va|ue Added) ls baslcally Lhe excess amounL lefL on afLer maklng a proper charge
for Lhe caplLal lnvesLed ln Lhe buslness lL dlfferenL ways economlc value added calculaLlon can be
done 1hey are


D|fferent types of nonom|n Va|ue Added (VA) Iormu|a are

VA NCA1 C* x CAI1AL
VA CAI1AL (rn*)
3VA A1 + IN1 (t) C* CAI1AL
4VA A1 kn ;DI1


Where
nCA1 neL CperaLlng roflL AfLer 1ax
C* CosL of CaplLal
CAl1AL Lconomlc book value of Lhe caplLal lnvesLed ln Lhe flrm
r reLurn on caplLal (nCA1/CAl1AL)
A1roflL AfLer 1ax
ln1+ lnLeresL expense of Lhe flrm
LMarglnal Lax raLe of Lhe flrm
kc CosL of equlLy
LCul1? LqulLy uLlllzed ln Lhe flrm


Important Ieatures and Advantages of VA Approan
lL acLs as performance measure whlch ls llnked Lo share holder value creaLlon ln all dlrecLlons
lL ls useful ln provldlng buslness knowledge Lo everyone
lL ls an efflclenL meLhod for communlcaLlng Lo lnvesLors
lL Lransforms Lhe accounLlng lnformaLlon lnLo economlc quallLy whlch can be easlly undersLood
by non flnanclal managers
lL ls useful ln evaluaLlng neL resenL value(nv) of pro[ecLs ln caplLal budgeLlng whlch ls
conLradlcLory Lo l88
lnsLead of wrlLlng Lhe value of flrm ln Lerms of dlscounLed cash flow lL can be expressed ln Lerms of
LvA of pro[ecLs

l?l 1hls approach was developed by SLern SLewarL Co and laLer wlLh dlfferenL names llke eLer
urucker referred lL as measure of LoLal facLor producLlvlLy feaLure magazlne as Lodays hoLLesL
flnanclal ldea and geLLlng hoLLer

Helsinki School oI Economics and Business Administration
Department oI Accounting and Finance

Economic Value Added as a management tool



Esa Mkelinen
E-mail: www.evanomics.com
9.2.1998




Table of contents
1 ntroduction *
1.1 The objective and motivation oI the study *
1.2 The structure oI the study *
1.3 Terminology *
1.4 Case-companies and applied conversions *
2 Economic Value Added and its characteristics *

2.1 The main theory behind EVA *
.1.1 The background of EJA *
.1. Market Jalue Added defined *
2.2 A review oI EVA as perIormance measure and as a yardstick oI wealth creation *
2.2.1 The discrepancy in accounting rate oI return (ROI) and EVA *
.. Some evidence on the correlation between EJA and share prices *
..3 Evidence on EJA in management bonus plans *
2.3 EVA as a perIormance measure in corporate world *
.3.1 Implications of EJA in corporate control *
.3. The main problems with EJA in measuring operating performance *
.3.3 How to improve EJA *
.3.4 EJA and allocation of capital *
.3.5 EJA vs. traditional performance measures *
.3.6 EJA vs. other Jalue-based measures *
3 EVA in Group-level controlling *
3.1 A rational deIinition oI EVA in business unit management *
3.1.1 Capital, NOPAT and Rate of return *
3.1. Taxes in EJA-formula *
3.1.3 Average cost of capital *
3.1.4 The essence of defining the capital costs accurately *
3.2 EVA in Bonus systems *
3..1 Arguments for using EJA in bonus systems *
3.. Characteristics of feasible EJA-based bonus system *
3..3 The impacts of EJAs imperfections to bonus system *
3..4 Possible EJA-based bonus plans *

3.3 Implementing EVA control inside organization *
4 EVA in case-SBU *
5 Summary and conclusions *
6 Literature references: *




ntroduction

Investors are currently demanding Shareholder value more strongly than ever. In the1980s,
shareholder activism reached unIoreseen levels with the companies in the United States
(Bacidore et al. 1997). ThereaIter also investors in Europe have increased the pressure on
companies to maximize shareholder value. Even in Finland the so-called Shareholder value
approach has gained grounds. This is due to e.g. abolishing the restrictions on Ioreign stock
ownership. Foreign investors emphasize and demand Iocus on Shareholder value -issues.
(Lyttyniemi 1996)
The Iinancial theory has since long suggested that every company`s ultimate aim is to maximize
the wealth oI its shareholders. That should be natural since shareholders own the company and as
rational investors expect good long-term yield on their investment. In the past, this ultimate aim
has however been oIten partly ignored or at least misunderstood. This can be seen e.g. Irom
measurement systems. Metrics like Return on investment and Earnings per share are used as the
most important perIormance measures and even as a bonus base in a large number oI companies,
although they do not theoretically correlate with the Shareholder value creation very well.
Against this background it is no wonder that so-called Value based measures have received a lot
oI attention in the recent years. These new perIormance metrics seek to measure the periodic
perIormance in terms oI change in value. Maximizing value means the same as maximizing
long-term yield on shareholders` investment.
Currently the most popular Value based measure is Economic Value Added, EVA™. There
has been a vivid debate Ior and against EVA in academic and management literature.
UnIortunately most EVA advocates and adapters have not acknowledged or discussed the Iaults
oI EVA, while they have praised the concept as a management tool. On the other hand most
criticism against EVA has kept to Iairly insigniIicant topics Irom the viewpoint oI corporate
control. There are currently very Iew articles dealing objectively with EVA`s strengths and
weaknesses as a management tool.

The objective and motivation of the study

This study seeks to clariIy the concept oI EVA especially Irom the viewpoint oI business unit
controlling. The objective oI the study is twoIold. Firstly, the study describes the theory and
characteristics oI EVA. This gives the Iramework to discuss the main objective: How companies
should use EVA considering both its Iavorable and unIavorable Ieatures? In this context, the
study also oIIers some recommendations oI how EVA should be used as a management tool. The
study tries to bring together the relevant theoretical issues and controlling practice. The topics
discussed are essential and current in the case-group as well as in many other companies
implementing EVA-approach in their organizations.


The structure of the study

The study consists oI three main chapters. The Iirst discusses the general theory behind EVA.
This chapter presents the background and basic theory oI EVA as well as main Iindings about
EVA in Iinancial literature. The chapter explains also in general what EVA has to give to
corporate world. The second chapter Iocuses on the use oI EVA in group-level controlling. It
discusses how EVA could be deIined in controlling and reporting, how it can be used in bonus
systems and what are the problems Iaced in implementing EVA. The third and Iinal main chapter
deals with EVA more practically inside the case SBU. The chapter presents with numerical
example the calculation oI EVA and the impacts oI a Iew diIIerent calculation methods. Chapter
also illustrates one possible way to allocate the capital costs in the case SBU.


TerminoIogy

Shareholder value Shareholder value is being used as a overall term covering various aspects
in thinking that promotes the interests oI shareholders. Normally the term also means a
company`s value to its shareholders i.e. market capitalization.
Shareholder value approach Shareholder value approach reIers to the Iocus oI organization and
management on acting within the interests oI shareholders. Hence it means Iocus on maximizing
the wealth oI shareholders (creating shareholder value).

Value based measures Value based measures are new perIormance measures that originate
Irom the shareholder value approach. They seek to measure the periodic perIormance in terms oI
shareholder value created (or destroyed).


ase-companies and appIied conversions
The subject will be discussed Irom both the viewpoint oI the case-group and the case-SBU
(Strategic business unit). The case-SBU is a unit oI the case-group. From the reader`s point oI
view it is completely irrelevant which real companies this study deals with. ThereIore the group
and the parent company will be called Group A or (parent) Company A. The Group and the
parent company have the same name also in reality. The SBU (daughter company) will be called
Company B or SBU B. Company B has been a kind oI EVA-pilot in the case-group, since it has
used EVA in reporting and bonus systems Irom the beginning oI this year (1997). This naturally
inIluences the whole study. Some problems are discussed in the light oI these early experiences.
All oI the Iigures in this study have been conversed linearly, so that meaning oI the Iigures and
the respective relations between the Iigures are still unchanged even though they do not relate to
any real numbers.


Economic VaIue Added and its characteristics

This chapter presents the main theory about EVA and shows some empirical Iindings around the
concept in Iinancial literature. The last section 2.3 tries to present what the theory oI EVA means
in practice Ior companies.


The main theory behind EVA
EVA measures whether the operating proIit is enough compared to the total costs oI capital employed. Stewart
deIined EVA (1990, p.137) as Net operating proIit aIter taxes (NOPAT) subtracted with a capital charge:
EVA NOPAT - CAPTAL COST
EVA NOPAT - COST OF CAPTAL x CAPTAL employed (1)
Or equivalently, iI rate or return is deIined as NOPAT/CAPITAL, this turns into a perhaps more revealing Iormula:
EVA (RATE OF RETURN - COST OF CAPTAL) x CAPTAL (2)
Where:
%

Rate oI return Nopat/Capital
Capital Total balance sheet minus non-interest bearing debt in the beginning oI the year
Cost of capital Cost of Equity x Proportion of equity from capital + Cost of debt x Proportion of debt from
capital x (1-tax rate). Cost oI capital or Weighted average cost oI capital (WACC) is the average cost oI both
equity capital and interest bearing debt. Cost oI equity capital is the opportunity return Irom an investment with
same risk as the company has. Cost oI equity is usually deIined with Capital asset pricing model (CAPM). The
estimation oI cost oI debt is naturally more straightIorward, since its cost is explicit. Cost oI debt includes also the
tax shield due to tax allowance on interest expenses. This derivation oI equity cost and WACC is explained later in
detail with chapter 4.2 (Company B`s EVA).
II ROI is deIined as above (aIter taxes) then EVA can be presented with Iamiliar terms to be:
EVA (RO - WACC) x CAPTAL EMPLOYED (3)
The idea behind EVA is that shareholders must earn a return that compensates the risk taken. In other words equity
capital has to earn at least same return as similarly risky investments at equity markets. II that is not the case, then
there is no real proIit made and actually the company operates at a loss Irom the viewpoint oI shareholders. On the
other hand iI EVA is zero, this should be treated as a suIIicient achievement because the shareholders have earned a
return that compensates the risk. This approach - using average risk-adjusted market return as a minimum
requirement - is justiIied since that average return is easily obtained Irom diversiIied long-term investments on stock
markets. Average long-term stock market return reIlects the average return that the public companies generate Irom
their operations.
EVA is based on the common accounting based items like interest bearing debt, equity capital and net operating
proIit. It diIIers Irom the traditional measures mainly by including the cost oI equity. Mathematically EVA gives
exactly the same results in valuations as Discounted cash Ilow (DCF) or Net present value (NPV) (Stewart 1990, p.3
and Kppi 1996), which are long since widely acknowledged as theoretically best analysis tools Irom the
Shareholders perspective (Brealey & Mayers 1991 p.73-75). These both measures include the opportunity cost oI
equity, they take into account the time value oI money and they do not suIIer Irom any kind oI accounting
distortions. However, NPV and DCF do not suit in perIormance evaluation because they are based exclusively on
cash Ilows. EVA in turn suits particularly well in perIormance measuring. Yet, it should be emphasized that the
equivalence with EVA and NPV/DCF holds only in special circumstances (in valuations) and thus this equivalence
does not have anything to do with perIormance measurement. This peculiar characteristic oI EVA is explained later
in detail.


The background of EVA

EVA is not a new discovery. An accounting perIormance measure called residual income is deIined to be operating
proIit subtracted with capital charge. EVA is thus one variation oI residual income with adjustments to how one
calculates income and capital. According to Wallace (1997, p.1) one oI the earliest to mention the residual income
concept was AlIred Marshall in 1890. Marshall deIined economic proIit as total net gains less the interest on
invested capital at the current rate. According to Dodd & Chen (1996, p.27) the idea oI residual income appeared
Iirst in accounting theory literature early in this century by e.g. Church in 1917 and by Scovell in 1924 and appeared
in management accounting literature in the 1960s. Also Finnish academics and Iinancial press discussed the concept
as early as in the 1970s. It was deIined as a good way to complement ROI-control (Virtanen 1975, p.111). Knowing
%

this background many academics have been wondering about the big publicity and praise that has surrounded EVA
in the recent years. The EVA-concept is oIten called Economic ProIit (EP) in order to avoid problems caused by the
trademarking. On the other hand the name "EVA" is so popular and well known that oIten all residual income
concepts are oIten called EVA although they do not include even the main elements deIined by Stern Stewart & Co.
For example, hardly any oI those Finnish companies that have adopted EVA calculate rate oI return based on the
beginning capital as Stewart has deIined it, because average capital is in practice a better estimate oI the capital
employed. So they do not actually use EVA but other residual income measure. This insigniIicance detail is ignored
later on in order to avoid more serious misconceptions. It is justiIied to say that the EVA concept Finnish companies
are using corresponds virtually the EVA deIined by Stern Stewart & Co.
In the 1970s or earlier residual income did not got wide publicity and it did not end up to be the prime perIormance
measure in great deal oI companies. However EVA, practically the same concept with a diIIerent name, has done it
in the recent years. Furthermore the spreading oI EVA and other residual income measures does not look to be on a
weakening trend. On the contrary the number oI companies adopting EVA is increasing rapidly (Nuelle 1996, p.39,
Wallace 1997, p.24 and Economist 1997/2). We can only guess why residual income did never gain a popularity oI
this scale. One oI the possible reasons is that Economic value added (EVA) was marketed with a concept oI Market
value added (MVA) and it did oIIer a theoretically sound link to market valuations. In the times when investors
demand Iocus on Shareholder value issues this was a good bite. Perhaps also pertinent marketing by Stern Stewart &
Co. had and has its contribution.


arket Value Added defined
EVA is aimed to be a measure that tells what have happened to the wealth oI shareholders. According to this theory,
earning a return greater than the cost oI capital increases value (oI a company), and earning less decreased value. For
listed companies Stewart deIined another measure that assesses iI the company has created shareholder value. II the
total market value oI a company is more than the amount oI capital invested in it, the company has managed to
create shareholder value. II the case is opposite, the market value is less than capital invested, the company has
destroyed shareholder value. Stewart (1990,153) calls that diIIerence between the company`s market and book value
as Market Value Added or MVA™ Ior short.
MarkeT Value Added
company`s total Market Value - capital invested
and with simpliIying assumption that market and book value oI debt are equal, this is the same as:
MarkeT Value Added
Market Value of Equity - Book Value of Equity (3)
Book value oI equity reIers to all equity equivalent items like reserves, retained earnings and provisions. In other
words, in this context, all the items that are not debt (interest bearing or non-interest bearing) are classiIied as equity.
Market value added is identical by meaning with the market-to-book -ratio. The diIIerence is only that MVA is an
absolute measure and market-to-book -ratio is a relative measure. II MVA is positive that means that market-to-book
-ratio is more than one. Negative MVA means market-to-book -ratio less than one.
According to Stewart Market value added tells us how much value company has added to, or subtracted Irom, its
shareholders` investment. SuccessIul companies add their MVA and thus increase the value oI capital invested in the

company. UnsuccessIul companies decrease the value oI the capital originally invested in the company. Whether a
company succeeds in creating MVA (increasing shareholder value) or not, depends on its rate oI return. II a
company`s rate oI return exceeds its cost oI capital, the company will sell on the stock markets with premium
compared to the original capital (has positive MVA). On the other hand, companies that have rate oI return smaller
than their cost oI capital sell with discount compared to the original capital invested in company. Whether a
company has positive or negative MVA depends on the level oI rate oI return compared to the cost oI capital. All
this applies also to EVA. Thus positive EVA means also positive MVA and vice versa. Stewart (p. 153) deIined in
his book the connection between EVA and MVA.
MarkeT Value Added Present value of all future eva (4)
Market value added is equal to present value oI all Iuture EVA. Increasing EVA a company increases its market
value added, or in other words increases the diIIerence between company`s value and the amount oI capital invested
in it.
The relationship with EVA and MVA has its implications on valuation. By arranging the Iormulas above we Iind a
new deIinition oI the value oI company:
Market Value of Equity
Book Value of Equity + Present value of all future eva (5)
Following Iigure will illustrate this relationship between EVA and MVA:


Figure 1 Company's market value depends directly on its future EVA.

The phenomenon with rate oI return and MVA is in one sense similar to the relationship between the yield and
market value oI a bond. II the yield oI a bond exceeds the current market interest rate (cost oI capital) then the bond
will sell at a premium (there is positive EVA and so the bond will sell at positive MVA). II the yield oI a bond is
lower than the current market interest rate then the bond will sell at discount (there is negative EVA and so the bond
will sell at negative MVA).
II the net assets or "capital" in the EVA Iormula (Iormula 2) reIlected the current value oI a company`s assets and iI
the "rate oI return" reIlected the true return, then there would not be much questioning about the theory between
EVA and MVA. AIter all, nobody questions the above connection between the market value, Iace value, interest rate
and yield oI a bond (obviously not since it hold almost perIectly also in practise). But with MVA and EVA things
are little bit more complicated. The term "capital" in Iormula 2 does not reIlect the current value oI assets, because
the capital is based on historical values. Nor does the "rate oI return" reIlect the true return oI the company. All
accounting based rate oI returns (ROI, RONA, ROCE, ROIC) Iail to assess the true or economic return oI a Iirm,
because they are based on the historical asset values, which in turn are distorted by inIlation and other Iactors
(Villiers 1997, p.287). Stewart deIines his rate oI return as return on beginning capital and as return aIter taxes but
these adjustments do not aIIect the problems attached to accounting rate oI return. The shortcomings oI accounting
rate oI returns and the current research on the subject are presented in detail in next section (2.2.1.).
The valuation Iormula oI EVA (Iormula 5) however is always equivalent to Discounted cash Ilow and Net present
value, iI EVA is calculated as Stewart presents. Thus the above valuation Iormula (Iormula 5) gives always the right
estimate oI value (same as DCF and NPV) no matter what the original book value oI equity is. This holds true even
though capital is not an unbiased estimate oI current value oI assets and rate oI return is not an unbiased estimate oI
the true return. That is because an increase in book value (Iormula 5) decreases the periodic EVA-Iigures (and oI
course a decrease in book value increases EVA-Iig.) and these changes cancel each other out. Also this phenomena
will be discussed more in next section (2.2.1).




A review of EVA as performance measure and as a yardstick of wealth creation
The discrepancy in accounting rate of return (RO) and EVA

Every project that a Iirm undertakes should have positive Net present value (NPV) in order to be
acceptable Irom the shareholders point oI view. This means that a project should have internal
rate oI return bigger than the cost oI capital. With practical perIormance measuring the internal
rate oI return can not be measured and some accounting rate oI return is used instead to estimate
the rate oI return to capital. Typically this rate oI return is some Iorm oI return on investment
(ROI). UnIortunately any accounting rate oI return can not on average produce an accurate
estimate oI the underlying true rate oI return. Following example illustrates this problem, which
is more thoroughly and with stronger theoretic background discussed below. The example
presents an investment project with initial investment oI 1200, duration oI 8 years, constant gross
proIit oI 210, IRR oI 11 and with no salvage value.

Table A: Example how RO estimates (both in different years and on average) the return of an investment
producing a RR of 11.


Year 1 2 3 4 5 6 7 8
ash fIows

nvestment

-1200

Gross
margin

210 210 210 210 210 210 210 21
Total Cash
flow

-990 210 210 210 210 210 210 21

Depreciation

-150 -150 -150 -150 -150 -150 -150 -1
Operating
income

60 60 60 60 60 60 60 60
BaIance
sheet

Beginning
assets

1200 1050 900 750 600 450 300 15
Ending
assets

1050 900 750 600 450 300 150 0
Accounting returns

RO
(beginning)

5,00 % 5,71 % 6,67 % ,00 % 10,00 % 13,33 % 20,00 % 40
RO
(average)

5,33 % 6,15 % 7,27 % ,9 % 11,43 % 16,00 % 26,67 % 0
True return and Net present vaIue

RR

11,0 % 11,0 % 11,0 % 11,0 % 11,0 % 11,0 % 11,0 % 11
NPV (WACC 10%) 29

ifferent averages of ROs

NormaI
average
Harmonic
mean
Geo-
metric
mean
NormaI mean weighted with assets

RO based on beginning
capitaI

13,59 % ,9 % 10,6 % ,9 %

RO based on average
capitaI

20,22 % 10,0 % 13,0 % 10,0 %





Figure 2: How RO estimates the return of an 8-year-project in different years. The true return or RR of the
project is 11 (shown as a vertical line).

As the above example indicates, ROI is a poor indicator oI the true rate oI return oI the project.
The Table A and the Figure 2 illustrate how ROI underestimates the IRR in the beginning and
overestimates it in the end on the period. In the remaining study this phenomenon is called
wrong periodi:ing. Besides that ROI periodizes the rate oI return wrongly in this example and it
also on average Iails to estimate the true rate oI return oI the project. That can be seen Irom the
diIIerent averages oI ROI in the bottom oI the Table A. None oI them is the same as IRR. In this
case ROI underestimates the true return. In the real liIe inIlation increases the cash Ilows
compared to the initial investment and thus ROI might as well overestimate the true return.
The wrong periodizing is with a real project perhaps even Iiercer than in the above example.
That is because usually in the real liIe projects the positive cash Ilows are generated only some

time aIter the beginning oI the period. For example investment in a new plant or machinery starts
to generate positive cash Ilows only aIter construction and installation phase. It also takes some
time to reach the Iull potential oI new machines and it might take some time to establish new
product in the markets.
However a company is typically a continuous stream oI investments and not a single big
investment. ThereIore the problem oI wrong periodizing oI accounting rate oI return is with
perIormance measurement not as big a problem as with a single investment. Furthermore, a
company has also a big proportion oI current assets that reduce the problem oI wrong
periodizing. That is because there are approximately as much current assets in the beginning as
in the end oI the investment period. However the wrong periodizing is a problem. Companies
can have a big proportion either very old or young assets. It is seldom the case that there are
equal proportions oI old, young and middle aged assets in a company`s balance sheet. Thus iI a
company has a lot oI new assets, new investments, it its likely to have low ROI although its true
rate oI return were suIIicient. In the opposite case, a company has very little new investments
compared to the major investments made in the past. This kind oI example can be e.g. a very old
paper mill: Since the original investment is depreciated, the assets are very small. ThereIore a
moderate operating cash Ilow might produce a very high ROI although the true return Ior the
whole investment period is even lower than the cost oI capital. This kind oI situation might give
the management wrong signals oI the true proIitability oI a business. Thus it might lead to either
overinvestments in mature businesses or underinvestments in proIitable businesses. Furthermore,
on the basis oI the above example (Table A and Figure 2), it is easy to see that ceasing
investments leads to increase in ROI in the short run.
In addition to wrong periodizing ROI is also otherwise a poor measure oI company`s true rate oI
return. The discrepancy between the accounting rate oI return and the true return is well
documented in economic literature. Harcourt (1965), Salomon and Laya (1967), Livingston and
Salomon (1970), Fischer and McGowan (1983) and Fisher (1984) concluded that the diIIerence
between accounting rate oI return and the true rate oI return is so large that the Iormer can not be
used as an indication oI the latter (REF De Villiers 1997, p.286-287). The eIIect oI inIlation on
the discrepancy was addressed by Salomon and Laya (1967), Kay (1976), Van Breda (1981) Kay
and Mayer (1986) and De Villiers (1989). They have shown that inIlation exacerbates the
discrepancy between accounting and true return. (REF De Villiers 1997, p.286-287) Although
inIlation strengthens the discrepancy, it should be pointed out that accounting rate oI return is
not, on average, equal to the true rate oI return even with no inIlation.
Salomon and Laya (1967) studied the accounting rate oI return (ARR) and the extent to which it
approximates the true return measured with IRR. The IRR oI a project can be measured, but
because the projects constituting a Iirm are usually not visible, the true yield oI a Iirm is
unknown (Salomon and Laya, 1967, p. 157). The authors thereIore studied a theoretical Iirm
made up Irom projects with a known IRR, and Iound that the ARR oI the Iirm diIIers Irom the
IRR oI the projects underlying the theoretical Iirm. The authors also show by means oI a

numerical simulation that inIlation increases the ARR oI a Iirm when IRR is being held at
constant. (REF De Villiers 1989, p. 494-495)
De Villiers (1989) studies the relationship between accounting and true rate oI return with
diIIerent asset structures. Typically Iirms can have three diIIerent type oI assets: Current assets
(inventories and receivables), Depreciable assets (e.g. machinery&equipment and buildings) and
Non-depreciable assets (e.g. land and stocks). De Villiers (1989) Iinds that iI a Iirm had nothing
but current assets, ROI (on average) would equal IRR. However, the more a Iirm has depreciable
assets (ceteris paribus), the more ROI overstates IRR. On the other hand the more Iirm has non-
depreciable assets (ceteris paribus) the more ROI understates IRR. In the real world companies
have assets oI all these three kinds and their relative proportions determine whether ROI
underestimates or overestimates IRR (and true rate oI return). De Villiers (1989) also presents
that even iI the assets are valued at their current value (and not at their historical value) there is
still some discrepancy between ROI and IRR. In other words when the understatement oI asset
value (caused by inIlation and historical values) is eliminated there is still discrepancy between
ROI and IRR that can thereby be ascribed to a deIiciency in the accounting proIit only. (De
Villiers 1989, p.502-503) De Villiers concludes that accounting rates oI return oI Iirms with
diIIerent asset structures are not comparable.
Alongside with inIlation rate and asset structure, also the length oI investment period aIIects the
discrepancy between ROI and IRR. Other Iactors being constant, the longer investment period
(economic liIe oI assets) the bigger is the discrepancy between ROI and IRR. This is obvious
since long investment period gives inIlation time to distort asset values. The eIIect oI the project
duration to the discrepancy is shown in the article oI De Villiers (1997, p.293-294).
Since EVA is calculated Irom the accounting based numbers and some version oI accounting
return is used in calculating EVA, it is obvious that all the discrepancies mentioned above aIIect
also EVA. II ROI overstates IRR then EVA also overstates the real shareholder value added. De
Villiers (1997) demonstrates with numerical examples how big these distortions can be. He also
suggests the use oI a modiIied concept oI EVA called adjusted EVA (or AEVA) in order to
radically decrease these discrepancies. The adjusted EVA is simple using current value oI all
assets in calculating the accounting rate oI return (ROI). De Villiers pointed out that one should
not use market values oI equity in calculating EVA as so oIten is done. Using market value oI
equity would be circular reasoning and lead to EVA oI zero. Instead current value (market value)
oI individual assets produce much more sound result, but they are admittedly oIten either very
diIIicult or even impossible to estimate. The use oI current value oI assets does not however
eliminate the discrepancy wholly but it does diminish it to a Iraction oI original discrepancy.
Storrie & Sinclair (1997) present also that EVA based on historical values can be somewhat
misleading. They Iirst demonstrate that the valuation Iormula oI EVA is theoretically exactly the
same as the valuation Iormula oI discounted cash Ilow (DCF) (Proved also by Kppi 1996).
AIter that Storrie & Sinclair also prove mathematically that this equivalence is due to the Iact

that the book value in EVA valuation Iormula is irrelevant in determining value. That is because
an increase in "book value oI equity" (Iormula 5 below) decreases the periodic EVA-Iigures
("present value oI Iuture EVA") and these changes cancel each other out.


Market value of equity Book value of equity + present value of future EVA (5)
Book value oI equity aIIects the periodic EVA Iigures in Iuture via capital costs: II book value oI
equity is too high then the capital costs in Iuture are also too high and the periodic EVA values
too low. These opposite changes in the two terms cancel each other and thus the market value oI
equity is always the same no matter oI the original book value. This is quite simple to
demonstrate with an example:
Suppose that a company does an asset revaluation oI 100 and thus increases its book value oI
equity Irom 500 to 600. The increase in net worth is naturally only an accounting trick and does
not aIIect the market value oI company. Let us examine the impact oI this trick to above EVA-
valuation Iormula (Iormula 5). The additional book value oI 100 increases periodical capital
costs with 100 x WACC (let us assume that this additional book value oI 100 is undepreciable,
which makes the example easier). II WACC is assumed to be 10, then the increase in periodic
capital costs is 10. How much does this periodic increase in capital costs decrease the present
value oI EVA? Well, iI the additional capital cost decreases periodic EVA by 10 with each year
then the whole impact can be calculated as a present value oI this 10. The present value oI this 10
is 10/0,1 100 (The Gordon model: the present value oI inIinite and constant cash Ilow: PV
D/r). Hence the decrease in present value oI EVA (-100) is with absolute value exactly the same
as the increase in book value oI equity (100). ThereIore this action does not aIIect the market
value oI equity calculated with EVA.
As we can see the decrease in the present value is exactly as big as the increase in book value, so
the initial book value does not matter in valuation. More generally prooIed:
Change in present value of future EVA (Change in book value x capital cost)/capital cost
Change in book value (6)
The situation does not change even iI the change in book value was depreciable. Then the
additional depreciation and additional capital costs correspond together the change in book
value.
This is the reason why a measure like EVA based on accounting items can produce theoretically
equivalent result with discounted cash Ilow although we know that accounting based measures
and accounting based rate oI returns are somewhat distorted. According to Storrie & Sinclair
(1997):

The mathematical equivalence is achieved because the EJA formula is a modified version of a
standard DCF formula within a mathematical construct in which all of the adfustments in the
EJA formula to the DCF must result net to :ero. The result of this construct is that it does not
matter what beginning capital base is used in an EJA valuation the result value will always be
identical.
EVA valuation Iormula gives the true value oI a Iirm no matter how the accounting is done. This
is achieved with combining income statement and balance sheet. Double entry bookkeeping
ensures that everything must add up and that accounting numbers have some connection with
economically meaningIul variables such as cash Ilow and dividends. This discipline applies
however only when proIit is computed on a "comprehensive income" basis:
Opening book value of equity
+ Accounting profit
- Dividends (less new issues of equity)
Closing book value of equity
For this relationship to hold, proIit must include all valuation adjustments aIIecting the balance
sheet. In some countries it is possible to violate against this principle. (O`Hanlon & Peasnell,
1996)
Although in valuation the capital base does not matter, it might cause harm in perIormance
measurement because the periodic values oI EVA are distorted. This distortion can be abolished
almost entirely by using current value oI assets in calculating capital costs, but again this might
be time-consuming and diIIicult and it might not pass a prudent cost beneIit analysis in practical
business situation (Dodd&Chen 1996, p.28). It should also be noted that in practice EVA seldom
corresponds DCF, because any adjustment made to EVA abolishes the mathematical equivalence
(Storrie&Sinclair 1997, p.5).
Also the original EVA consulting company Stern Stewart & Co has noticed and reacted to the
distortions in periodic EVA Iigures. The company recommends that aIter introducing a simple
deIinition oI EVA, the concept can be reIined to the degree that makes sense taking into account
both the costs and beneIits oI complicating the model. According to Stern Stewart, two most
important ways to decrease accounting distortions are introducing a modiIied depreciation
schedule or imposing a level capital charge throughout the liIe oI the asset. Either oI these
prevents EVA Irom increasing simply because an asset is growing older. (Kroll 1997, p.105) The
level capital charge means probably that the sum oI depreciation plus capital cost oI an asset is
the same every year during the economic liIe oI the asset in question. Normally the depreciation
is the same every year (straight-line depreciation) and thus the sum oI depreciation and capital
costs is big in early years and diminishes towards the end.
%



$ome evidence on the correlation between EVA and share prices
As already presented (in chapter 2.1.2.) according to the EVA-theory the market value oI a
company is its book value plus the current value oI Iuture EVA (Iormula 5). This strict
relationship between EVA and the market value oI a company suggests that EVA drives the
market values oI shares. This relationship between EVA and MVA has been studied in the recent
years in many studies with many methods - and with diIIerent results.
Stewart (1990, p.215 - 218) has Iirst studied this relationship with market data oI 618 U.S.
companies. Stewart presents the results in his book "The quest Ior value". He states that EVA
and MVA correspond each other in reality quite well among US companies (the data was Irom
late 1980`s). Only the relationship between negative EVA and negative MVA does not hold very
well. According to Stewart, this is because the potential oI liquidation, recovery, recapitalization,
or takeover sets a Iloor on a company`s market value (Stewart p.217). For example with
companies which have a lot oI Iixed assets this is quite easy to understand. Market value will
always reIlect the value oI assets even though the company has very low or negative rate oI
return (and so theoretically it should sell a lot below book value). That is because the company
can always be liquidated; the owners have an option to liquidate the assets iI the return looks
week also in the Iuture. On the other hand markets do not believe that the weak returns can go on
Iorever. Markets are expecting a chance, an improvement, in the long run. II EVA is positive, the
relationship is more direct. Then the market valuation happens on the basis oI return and growth
potential and not on the basis oI liquidation or recovery value. Stewart Iinds also that MVA and
EVA correspond each other best when we talk about changes in EVA and MVA and not the
absolute levels. Changes in EVA and MVA are not aIIected so much by accounting distortions
and inIlation than the absolute values.
Lehn and Makhija (1996) study EVA and MVA as perIormance measures and signals Ior
strategic change. Their data consists oI 241 U.S. companies and cover years 1987, 1988, 1992
and 1993. The researchers Iirst Iind out that both measures correlate positively with stock returns
and that the correlation is slightly better than with traditional perIormance measures like return
on assets (ROA), return on equity (ROE) and return on sales (ROS). Additionally they study how
companies` perIormance, as measured in terms oI EVA and MVA, aIIect on the CEO Iirings.
Finally they examine the relationship between EVA/MVA and corporate Iocus. Lehn and
Makhija Iind an inverse relation between EVA/MVA and abnormal CEO turnover. They also
Iind that Iirms with greater Iocus on their business activities have signiIicantly higher MVA than
their less Iocused counterparts. Lehn and Makhija conclude that their results suggest EVA and
MVA to be eIIective perIormance measures that contain inIormation about the quality oI
strategic decisions and serve as signals oI strategic change.
%

Uyemura, Kantor and Pettit (1996) Irom Stern Stewart & Co present Iindings on the relationship
between EVA and MVA with 100 bank holding companies. They calculate regressions to 5
perIormance measures including EPS, Net Income, ROE, ROA and EVA. According to their
study the correlations between these perIormance measures and MVA are: EVA 40, ROA
13, ROE 10, Net income 8 and EPS 6. The data is Irom the ten-year period 1986 through
1995.
O`Byrne (1996) Irom Stern Stewart & Co uses capitalized EVA as independent variable in a
regression where market value divided by capital is the dependent variable. He Iinds that the
level oI EVA explains 31 oI the variance in market value, whereas the level oI net operating
proIit aIter taxes explains only 17. When looking at changes in EVA and market value
O`Byrne Iinds that changes in EVA explain 55 oI variations in changes in market value.
Changes in NOPAT explain only 33.
Milunovich and Tsuei (1996) review the correlations between MVA and several conventional
perIormance measures in the computer industry. They Iind EVA to correlate somewhat better
with MVA than the other measures. R squared is Ior EVA 0,42, Ior EPS growth 0,34 and Ior
ROE and EPS 0,29.
Grant (1996) calculates regression statistics between the MVA-to-capital and EVA-to-capital
ratios Irom the data oI 983 Iirms. He Iinds explanatory levels (R squared) oI 32 with statistical
signiIicance. Regressing MVA-to-capital and the spread between return and cost oI capital
reveals R squared oI 37.
Dodd and Chen (1996) study the correlation between stock returns and diIIerent proIitability
measures including EVA, non-adjusted residual income, ROA, EPS and ROE. In their study
ROA explained stock returns best with R squared oI 24,5. The R squared Ior other metrics are:
EVA 20,2, residual income 19,4 and EPS, ROE approximately 5-7. The writers concluded
that Iirms adopting EVA might as adopt simple residual income concept, while residual income
correlates with share prices almost as well as its adjusted version called EVA. The study is based
on 566 U.S. companies Irom 1983-1992.
Biddle. Bowen and Wallace (1996) present evidence on the relative and incremental inIormation
content oI EVA, residual income, earnings and operating cash Ilow. According to the abstract oI
the study, the writers conclude that "residual income and/or EVA add incremental inIormation in
some settings, but that, on average, neither dominates earnings as a perIormance measure".
Telaranta`s study on Finnish Stock markets
The only public study about the correlation oI EVA and share prices that has been done on
Finnish data is Irom Tero Telaranta 1997. The study and article based to it concluded that EVA
is not any better than traditional perIormance measures. Many Finnish corporate managers have

taken these conclusions very seriously and thereIore it is more than justiIied in this context to
examine the study more thoroughly that the studies above.
Telaranta (1997a) study how residual income variables explain movements in market valuations
oI Finnish companies. The data consist oI 42 Finnish industrial companies during 1988 1995.
Only 26 oI the companies were listed the whole period and 16 were listed Ior shorter period.
During the research period both the aggregate Market value added and the non-weighted average
return on stock among the sample companies are negative. That is because the whole Finnish
economy and stock markets experienced a severe recession in the middle oI research period
around the turn oI the decade (1990). Telaranta (1997a) use various diIIerent methods in
assessing the ability oI diIIerent measures to explain market movements. As dependent variables
he use MVA, market-to-book ratio and excess return on stock. As independent variables
Telaranta use two versions oI economic proIit (residual income) and three versions oI Eduard-
Bell-Ohlson -Iigure (near residual income) as well as traditional accounting based perIormance
measures like EBITDA, Operating proIit, NOPAT, Net earnings and Cash Ilow. These all
measures are regressed also as percentages oI sales and as percentage returns on capital, although
using residual income variables in that way is not necessarily theoretically sound. The reason Ior
this is probably to get some comparison material Ior measures like ROI, ROE, Operating proIit
and Net earnings .
Telaranta`s results (1997a) indicate the level oI Economic proIit (the nearest measure to EVA oI
all those variables that Telaranta use) to explain 30,7 oI the level oI Market value added as the
next best measure NOPAT explain 30,16. When talking about changes instead oI absolute
levels, Economic ProIit is the best with R squared oI 17,18 whereas Operating proIit is the
second best with R squared oI 16,64. In several other regressions residual income variables are
generally Iound to be the best measures although with a tiny diIIerence compared to some
accounting based variables. In some regressions some accounting based variable is even Iound to
be slightly better than Economic ProIit, but these regressions are not very meaningIul Ior one oI
the Iollowing two reasons:
The overall explanatory level with these regressions is Iar below 5.
These regressions are on those variables that are all expressed as percentage oI sales (e.g.
Economic ProIit divided with turnover). Economic ProIit looses its meaning when expressed as
percentage oI sales i.e. there is no theory suggesting that variable "Economic ProIit/Turnover"
should correlate with share prices. Hence there is no meaning attached to the use oI Economic
ProIit with these regressions. Furthermore the explanatory level with these regressions is under
10.
Telaranta concludes his results to indicate that residual income variables are Iound to explain the
movements in market capitalization with statistical signiIicance. He however Iounds the

explanatory level to be quite low. Telaranta also presents that residual income variables are not
Iound to explain stock returns statistically signiIicantly better than accounting based measures.
Telaranta`s results indicate that Economic ProIit is the best variable in the study explaining
market movements, but that the diIIerence compared to other measures is insigniIicant. The
diIIerence to accounting based measures is naturally low in terms oI statistical signiIicance
because the data consists oI such a small number oI Iirms. The previous studies on the subject
have on average about 15-Iold number oI companies, so the statistical signiIicance between
residual income and accounting based measures is also respectively easier to achieve.
Telaranta also states that the overall explanatory lever is lower than in previous studies. On the
other hand Telaranta Iound an explanatory level oI 30 (Economic ProIit explains MVA) which
settles moderately with other studies (&yemura et al, EJA 40), (OByrne, EJA 31),
(Milunovich and Tsuei, EJA 4), (Grant, EJA 3) and (Dodd and Chen, ROA 4,5, EJA
0,, residual income 19,4). Telaranta achieve also Iar lower explanatory levels in
regressions with Economic ProIit as percentage oI sales and Economic ProIit as percentage
returns on capital. These regressions are however not comparable because they are not based on
any theory.
Everyone should also notice the eIIects oI the research period on the results. The aggregate
Market value added and the non-weighted average return on stock among the sample companies
are negative during the period because oI the recession. On the other hand Stewart (1990, p.217)
has emphasized that possibility oI liquidation sets a Iloor on company`s MVA. Telaranta`s
research period causes thus major bias against EVA. Another unmentioned bias is the use oI
HEX-index. Especially in the latter halI oI the period Nokia`s and couple oI other companies`
stocks have a very big weight in HEX-index (Nokia currently about 35). ThereIore the impact
oI one single company is very large in Telaranta's results. II Nokia's stock perIormance does not
correlate very good with Nokia's EVA it would certainly aIIect the results. Well, Nokia increased
its market value to more than 10-Iold compared to the beginning oI the period and that was oI
course due to proIitable growth prospects (growth in EVA) that the company had ahead.
ThereIore Nokia's EVA during 1988-1995 hardly explains very much oI the change in Nokia's
market value during the same period. Nokias turnaround Irom big wealth destroying
conglomerate into a big, dynamic wealth creating telecommunications company was Iirstly seen
in share prices and not in proIitability measures since investors are staring at Iuture proIit
prospects (EVA) above the prevailing perIormance.
Telaranta (1997b) summarize some oI his results in Finnish management journal "Talouselm"
in September 1997 and argue that EVA does not create any value added applied as measure or
bonus base in companies. Telaranta presents in the article only the results Irom the regressions
where Economic ProIit is divided with sales and capital. These regressions do not rank EVA best
like the other regressions do. As presented above these regressions are theoretically not sound
since any theory does not suggest the variables: "EVA/Turnover" and "EVA/Capital" to correlate

with share prices. Also the overall explanatory level oI the chosen regressions are very week
which also casts doubts on the motives oI selection. Why are not the regressions on absolute
values selected even though they are theoretically and with explanatory levels Iar better than
those presented in Talouselm? Telaranta`s article has gained a lot oI criticism aIterwards
(Kurikka 1997 Irom University oI Technology, Torppa&Lumijrvi 1997 Irom KPMG
Management Consulting, Lukka&Tuomela 1997 Irom Turku School oI Economics and
Martikainen & Kallunki 1997 Irom University oI Vaasa). Main points oI this criticism are:
Periodic EVAs can not explain changes in market values caused by changes in long term EVA
(Martikainen&Kallunki 1997 and Torppa&Lumijrvi 1997).
Telaranta can not criticize EVA to be week in corporate control and bonus systems, while he has
not studied it (Lukka&Tuomela 1997).
General about the correlation of EVA and share prices
The criticism on Telaranta`s study mentions at least one Iundamental hindrance in estimating
EVA-theory with stock price correlations: Market values are above all based on expectations
about the Iuture cash Ilows. Changes in the current share prices thus reIlect changes in Iuture
cash Ilow and Iuture EVA expectations. ThereIore current EVA can never explain current share
prices very well. Change in current EVA might imply some change in Iuture EVA and thereIore
EVA has some explanatory power. On the other hand the change in Iuture EVA is surely visible
also in other measures than EVA. ThereIore it is understandable that the other measures have
almost as much explanatory power and it is also understandable that the explanatory level is
quite low with every measure. Still, current research on the subject seems to suggest that EVA
has some additional inIormation compared to conventional measures. However EVA should not
be viewed as a magic wand, which can explain current share prices with current perIormance.
The power oI EVA is elsewhere, in the Iield oI corporate control, and the rest oI this study tries
to illuminate it. However iI EVA is used as Discounted cash Ilow to estimate current valuations
with Iuture EVA estimates it might be quite inIormative. Perhaps this is why CS First Boston has
trained its research staII in EVA analysis, and Goldman Sachs is about to introduce EVA as "a
power tool in the analytical tool kit", as global research chieI Steve Einhorn Irom Goldman
Sachs put it (Topkis, 1996, p.265).
OI course the relationship between EVA and MVA can and also has to be tested empirically, but
the best way to execute these tests is not to correlate periodic EVA and periodic MVA. One way
to assess this theory is to calculate MVAs Ior certain year (-s) and compare them with EVAs
Irom that year on. That is also the way Stewart does in his study. The problem will still be that
MVA accounts Ior all Iuture EVA and not just Ior EVA oI certain period. The shorter period we
take the bigger mistake we make in scope. On the other hand the longer period we take, the
worse investors` (EVA) expectations and reality correspond each other. II we compare MVA in
1980 and EVAs in 1981-1990, we assume that investors know in 1980 what is company`s EVA

in 1981-1990. In the real liIe investors do not have crystal ball oI ten years. EVA critics should
construct their studies to test the EVA theory (MVA is discounted EVA) and not purely periodic
correlation with share prices. According to the theory, EVA corresponds MVA and not share
prices. That is because simply pouring more money in the company can raise share prices.
However EVA and MVA do not rise unless that incremental money earns more than its cost oI
capital. ThereIore e.g. EPS and NOPAT capture much better the share price impacts oI NPV
negative investments than EVA. Tests should also take into account the liquidation Iloor oI the
value oI company, because it is part oI the EVA-theory Stewart presents. Thirdly and above all,
EVA critics should present some logical and theoretical arguments against EVA. There is no
sense making hasty conclusions on the grounds oI empirical tests iI there is no single logical
argument along. Investors have always been interested in return and risk and EVA measures
these vital things theoretically better than traditional measures.
The distortions in EVA probably aIIect the correlation between EVA and share prices. This
might also be one reason why in spite oI its "theoretical superiority", EVA does not correlate
with share prices in every study so much better than other accounting based measures like ROI
and EPS. The distortions are probably also the main reason why the changes oI EVA correlate
better with share prices than absolute values. It is also remarkable that those studies excluding all
adjustments to EVA (Telaranta 1997, Dodd&Chen, 1996) show least evidence on the correlation.


Evidence on EVA in management bonus plans
Wallace (1997) study the eIIects oI adopting management bonus plans based on residual income
measures. The sample in the study consists oI Iorty Iirms that have some residual income
measure, mainly EVA, as bonus base. This sample is compared to sample oI same size consisting
oI similar companies where the bonus is tied to accounting based measures. Wallace tests with
various methods the management actions in these sample groups and concludes that ".I
interpret the results as being consistent with a residual income-based perIormance measure
providing incentives Ior managers to act more like owners, thus mitigating the inherent conIlict
between managers and shareholders." Wallace`s tests support the adage "you get what you
measure", with signiIicant increases noted in residual income Ior the Iirms adopting residual
income based compensation relative to the comparison group. The Iirms that adopted residual
income based compensation outperIormed the market over the twenty-Iour month period by over
4 -points in cumulative terms.


EVA as a performance measure in corporate worId
mplications of EVA in corporate control

In the previous chapters EVA was veriIied to suIIer Irom the same accounting distortions as any
accounting rate oI return (e.g. ROI). ThereIore EVA might in some occasions give somewhat
misleading signals oI the true value added to shareholders. In spite oI this Iact EVA has become
a very popular perIormance measure, perhaps because applying it has some powerIul impacts on
organizational behavior.
Unlike conventional proIitability measures EVA helps the management and also other
employees to understand the cost oI equity capital. At least in big public companies, which do
not have a strong owner, shareholders have oIten been conceived as a Iree source oI Iunds.
Similarly, business unit managers oIten seem to think that they have the right to invest all the
retained earnings that their business unit has accumulated although the group would have better
investment opportunities elsewhere. EVA might change the attitude in this sense because it
emphasizes the requirement to earn suIIicient return on all capital employed.
Including capital costs in the income statement helps everybody in the organization to see the
true costs oI capital. Rate oI return does not work that way because nobody can explicitly see the
costs caused by e.g. inventories, receivables etc. The approaches showing the consequences oI
invested capital under the line as proIit (with ROI) or over the line as cost (with EVA) are totally
diIIerent. That is why organizations tend to increase their capital turnover aIter introducing EVA,
although they have Iormerly used ROI that ought to take into account the capital as well. When
calculating EVA, the cost oI equity (and debt) can be subtracted in the income statement earlier
than aIter the net operating proIit. II all the revenues and costs are grouped by Iunctions or by
processes, then it is oI course practical to allocate the capital costs to these Iunctions or
processes. The capital costs can also be allocated directly to products. Part oI the capital costs are
variable in nature (inventories, trade receivables) and thus they Iluctuate according to the sales
volume. II the true capital costs were not included Iully in product costs, then those cost
calculations (Ior price determination) are misleading. The error is the bigger, the more capital
intensive the production is.
At best EVA can be a new approach to view business. Perhaps the biggest beneIit oI this
approach is to get the employees and mangers to think and act like shareholders. It emphasizes
that in order to justiIy investments in the long run they have to produce at least a return that
covers the cost oI capital. In other case the shareholders would be better oII investing elsewhere.
This approach includes that the organization tries to operate without lazy or excess capital and it
is understood that the ultimate aim oI the Iirm is to create shareholder value by enlarging the
product oI positive spread (between return and cost oI capital) multiplied with the capital
employed. The approach creates a new Iocus on minimizing the capital tied to operations. Firms
have so Iar done a lot in cutting costs but cutting excess capital has been paid less attention. The
power oI EVA-approach is something that most academic studies about EVA and share price
correlation Iail to trace. The only way to assess the eIIects oI this approach is to compare two
sample groups, other representing Iirms that use EVA and other Iirms that do not. Only the study

oI Wallace (1997) meets this requirement and his study also suggests superior perIormance with
the companies using EVA.


The main problems with EVA in measuring operating performance
As presented earlier EVA and ROI are poor in periodizing the returns oI a single investment.
They underestimate the return in the beginning and overestimate it in the end oI the period. Some
growth phase companies or business units have a lot oI new investments. Such growth phase
companies are likely to have currently negative EVA although their true rate oI return would be
good and so their true long-term shareholder wealth added (true long-term EVA) would be
positive. That is also the reason why EVA is criticized to be a short-term perIormance measure.
Ceasing investments can indeed increase short-term EVA. Some companies have concluded that
EVA does not suit them because oI their Iocus on long-term investments that do not occur in a
continuous stream. An example is oIIered by American company GATX (Glasser 1996), which
leases transportation equipment and makes Iairly long-term investments.
However it should be remembered that the ultimate aim is still to create value Ior shareholders.
Only earning higher rate oI return than the cost oI capital in the long run can do this. The Iact
that the required good Iinancial perIormance is not expected now but only in the Iuture is not a
reason to leave out Iinancial measures. ThereIore periodic Iinancial perIormance measures are
always important no matter what business Iield the company operates at. The companies stating
that EVA does not suit them because oI their long investment horizon are actually presenting that
they can manage without measuring the ultimate objective.
This shortsightedness is an inevitable Ieature with all proIitability measures. They all measure
current proIitability i.e. how current revenues cover current costs. The true return or true EVA oI
long-term investments can not be measured objectively with any perIormance measure because
Iuture returns can not be measured; they can only be subjectively estimated. II Iinancial
perIormance measures are wanted to maintain as objective measures oI current Iinancial
perIormance, they can not include Iuture estimates. With most Iinancial perIormance measures
the only subjective component is the depreciation schedule. Some Iinancial perIormance
measures like CFROI, CVA and DCF have modiIied depreciation schedules that even out the
proIitability during the investment period. This oI course decreases the objectivity oI these
measures.
The periodizing problem oI Iinancial perIormance measures has to be managed with Iocus on
long-term. Even though current Iinancial perIormance is poor, there is no reason to view things
with narrow, short-term perspective. This wrong periodizing will even out in the long run, iI the
investments really are proIitable. Furthermore the extent oI this problem can be estimated; the
average age oI company`s asset portIolio can be taken into account in interpreting periodic EVA.

It can be expected that companies with a lot oI new and thus undepreciable assets have negative
EVA in the near Iuture.
The companies that have invested heavily today and expect positive cash Ilow only in a distant
Iuture are extreme examples. For these growth companies - Iacing proIitable long-term
opportunities with negative short-term cash Ilows - EVA is probably not a suitable primary
perIormance measure. The perIormance oI growth companies like some telecommunication
operators (heavy investments in inIrastructure with very long payoIIs) and other high-tech
companies is perhaps measured better with market share, change in market share, sales growth
etc. That is because the current Iinancial perIormance oI these companies can not be very
attractive measured with any metrics.
It certainly holds also more generally that EVA or any other Iinancial perIormance measure do
not in itselI provide managers with suIIicient inIormation. Financial measures tell us the outcome
oI many diIIerent things. They usually hide the causes oI good or bad proIitability. The good or
bad perIormance oI individual processes is seldom visible in Iinancial perIormance measures.
Some other measures pinpoint the current situation oI critical success Iactors much better.
ThereIore every company should use many measures in estimating how their plans are going and
strategic goals are reached.
The new but Iamous concept called Balanced Scorecard (Kaplan&Norton 1996) presents that
companies should use several diIIerent perspectives in measuring perIormance. The perspectives
suggested are (Kaplan&Norton 1996, p.9):
Financial (How should we appear to our shareholders?)
Customer (How should we appear to our customers?)
Internal Business Process (To satisIy our shareholders and customers, what business processes
must we excel at?)
Learning and growth (To achieve our vision, how will we sustain our ability to change and
improve?)
The relative weight oI each group oI measures (perspective) depends heavily on the business
Iield and situation oI the company. ProIessors Kaplan and Norton present that in order to IulIill
Iinancial objectives set by shareholders, the company should concentrate on besides Iinancial
measures also on measures oI the other perspectives. II a company has measured customer
perspective well and reacted in it with operations (internal business process perspective), the
result is oIten improved Iinancial perIormance. Financial measures do not oIten show the reasons
but the consequences. ThereIore it is utmost important to have also other measures. Sometimes
Iocus on EVA and shareholder value is incorrectly viewed as opposite approach to Balanced
Scorecard. On the contrary proIessors Kaplan and Norton (1996, p. 49) present that EVA is one

suitable and widely used Iinancial perIormance measure Ior Iinancial perspective. According to
Kaplan and Norton (1996) the Iinancial perspective is the critical summary and the main goal. It
must not be neither over- nor underemphasized. A failure to convert improved operational
performance in the Scorecard, into improved financial performance should send executives back
to their drawing boards to rethink the companys strategy or its implementation plans."
(Kaplan&Norton 1996, p.34). In the end, every strategic plan has to convert into long run
proIitability in order to be justiIied.
A good example oI the necessity oI diIIerent measures is provided with the browser and other
Internet soItware producer Netscape. The company did huge losses in its early years but still it
was viewed as valuable company because oI the expected big positive Iuture cash Ilows. There
would have been no sense in measuring Netscape's current EVA and steering the company on the
basis oI it. On the other hand company must have some plans about how and when they are
going to cash in their lucrative prospects. Enormous growth and customer satisIaction does not
comIort the owners iI the company can not make money with them. Actually Netscape is
currently in a dangerous zone because its sales revenues Ior 1997 are $533 Million, Operating
loss -$132 Million and total shareholders equity $429 Million. II it can not improve its Iinancial
perIormance quickly or raise more capital Irom shareholders it will go into bankruptcy in less
than two years.


The impacts of EVA`s accounting distortions in performance measurement
EVA suIIers (as Iound out in chapter 2.2) also Irom other distortions than only wrong
periodizing. As ROI Iails (on average) to estimate the underlying true return, so does the periodic
EVA Iigure Iail to estimate (on average) the value added to shareholders, because oI the inIlation
and other Iactors. Using the current value oI assets instead oI book values (De Villiers 1997,
p.299) can eliminate this problem almost totally. The extent oI this problem depends very
heavily on the asset structure (how big relative are the proportions oI current, depreciable and
non-depreciable assets) and on average project duration. Thus the extent and direction oI this
problem can be estimated. The EVA targets can be adjusted accordingly, although this is not
necessary an easy task.
It is however reasonable to admit that this problem is usually so small that no adjustments are
necessary. EVA can be and also has been applied successIully in many companies without any
special adjustments to capital base (Birchard 1996). This is also the way that companies have
calculated their ROI Ior decades without massive criticism. So Iar this distortion in ROI has been
widely ignored, although the theoretical weakness in using historical values in calculating ROI
has been acknowledged e.g. in Finland at least since 1970`s (Virtanen 1975, p.102). This might
tell us something about the importance and extent oI the eIIects with this phenomenon. On the
other hand it might also tell how diIIicult these distortions are to bypass.
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ow to improve EVA
There are countless individual operational things that create shareholder value and increase
EVA. OIten EVA does not directly help in Iinding ways to improve operational eIIiciency except
when improving capital turnover. Nor does EVA help directly in Iinding strategic advantages
that enable a company to earn abnormal returns and thus create shareholder value. It is however
oIten helpIul to understand the basic ways in which EVA and thus the wealth oI shareholders can
be improved. Increasing EVA Ialls always into one oI the Iollowing three categories:
Rate oI return increases with the existing capital base. It means that more operating proIits are
generated without tying any more capital in the business.
Additional capital is invested in business earning more than the cost oI capital. (Making NPV
positive investments.)
Capital is withdrawn or liquidated Irom businesses that Iail to earn return greater than the cost oI
capital.
The Iirst method includes all the countless ways to improve operating eIIiciency or increase
revenues. OI course increasing rate oI return with current operations and new investments (that is
categories 1 and 2) are oIten linked; in order to improve the eIIiciency oI ongoing operations,
companies oIten do investments which enhance also the return on current capital base.
The Iact that the wealth oI shareholders increase with investments returning more that the cost oI
capital (category 2) is probably known in organizations iI they also use some kind oI weighted
average cost oI capital (WACC) and Net present value (NPV) methodology in investment
calculations. This rule is actually completely same as accepting only NPV-positive investments.
The third category, withdrawing capital, is probably not so widely understood and applied as the
previous ones. It is however also very important to realize that shareholder value can also be
increased iI capital is withdrawn Irom businesses earning less than the cost oI capital. Even iI an
operation has positive net income, it might pay to withdraw capital Irom that activity. It is also
kind oI withdrawal when access inventories and receivables and thus the capital costs caused by
them are reduced without corresponding decreases in revenues.
These categories and ways to improve EVA might appear to be quite simple. They are certainly
not new ways to improve the position oI shareholders. Decreasing cost oI capital is not included
in this list oI methods. That is because it can not normally be done without changing line oI
business and in that way changing business risk. Changing Iinancial leverage aIIects WACC
only slightly via increased tax shield. The eIIects oI leverage on capital costs are discussed more
thoroughly in chapter 3.
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EVA and allocation of capital

EVA is a capital allocation tool both inside a company and also with a broader perspective inside
the whole economy. EVA sets a minimum acceptable perIormance level to the rate oI return in
the long run. This minimum rate oI return is based on the average (risk-adjusted) return on the
equity markets. The average return is a benchmark that should be reached. II a company can not
achieve the average return, then the shareholders would be better oII iI they allocated their
capital to another industries or to another companies.
There are some lines oI business where the average return is in the long run very hard to achieve
even with competent management and with no competitive disadvantages. That is normally
because these business Iields are mature, have excess capacity and thus have very Iierce
competition. OI course every business Iield has also some companies that can generate high
proIitability in spite oI the tight situation, but the average return on these businesses is low.
These kinds oI businesses with low average return have been e.g. steel industry, automobile
industry, Iorest industry, some consumer electronics industries (e.g. television manuIacturers)
etc. The low return with these Iields is likely to improve in the course oI time, but it must be
emphasised that the question is not about normal business cycles but about long-term
disequilibrium between supply and demand i.e. overcapacity. This overcapacity leads these Iields
inevitably to below average returns.
This kind oI Iields with low expected return can be identiIied easily with the market valuations.
II the Market value added (MVA) is on average negative with companies oI a business Iield it is
a sign that markets do not believe the return with this Iield to be suIIicient in the long run.
Negative MVA is a sign that markets believe that a company produces negative EVA in the long
run as presented in section 2.1.2.
Majority oI the companies with the mature businesses does produce a positive cash Ilow,
although the return is below average. That cash Ilow in turn is partly distributed to owners as
dividends and partly invested back in business. These plowback investments earn the same
below average return as the old investments and thus they destroy the wealth oI shareholders. In
order not to do so, these companies should pay out much more oI the Iree cash Ilow than
currently. Generous dividend policy should continue as long as the expected return is below
average return oI similar risky investments. This same pattern could be applied within the
diIIerent business units oI a company. Only those business units that can earn at least average
return - produce positive EVA in the long run - are entitled to expand their operations with
investments.
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In the real liIe it is not necessarily easy to classiIy business lines that oIIer below average returns
in the long run, because almost all industries have low or even negative return at some point oI
business cycle. Furthermore there are always companies that are able to generate suIIicient
returns even with otherwise unproIitable Iields. Thirdly all old industries do not necessary end up
to be unproIitable since overcapacity arises only in special circumstances.
It is oIten hard Ior managers to acknowledge that some business lines are less productive than
others are on average. There is however some evidence clearly suggesting that some Iields are on
average less proIitable that others. First oI all there are some business lines where all publicly
traded companies have negative MVAs suggesting that markets are expecting negative long-term
EVA Ior the Iield in the Iuture. Furthermore markets have clearly shown to reward certain
companies that give up their excess equity capital through share repurchases instead oI pouring
the money back in business. Especially the big American steel and paper manuIacturers that have
announced about share repurchasing programs have experienced substantial share price increases
(already at the moment oI announcement). The shareholder value increases are in these cases due
to avoiding the possibility to destroy value with unproIitable investments. Shareholders can
invest the money through markets and get easily the average market return whereas these
companies would hardly have reached it. On the other hand, iI highly proIitable companies like
MicrosoIt or Nokia announced that they are going to buy back their shares in order to give up
excess equity, their share prices would probably not shoot up but down. That is because their
share prices are Ior the most parts based on the proIitable growth with NPV and EVA positive
investments.
The problem oI investing Iree cash Ilow back in unproIitable businesses is widely discussed in
literature as part oI agency problems (e.g. Jensen 1986). Managers oI the unproIitable companies
are not willing to give up excess capital since they normally want to grow the operations under
their control. ThereIore owners or group oIIicers should control investments and develop
steering or incentive systems that prevent this kind oI behaviour with those Iields where it can
occur. The misuse oI Iree cash Ilow to unproIitable investments aIIects directly EVA-Iigures and
thus using EVA as perIormance measure might decrease this problem. AIter all EVA is aimed to
be a measure that is consistent with NPV i.e. NPV negative investments decrease EVA and NPV
positive investments increase EVA. The study oI Wallace (1997, p.15-16) presents empirical
evidence that basing compensation on EVA decreases the overinvestments in mature industries.
In this context it is important to avoid short run thinking. Negative EVA Iigures at some period
does not always mean that the Iield is unproIitable in general or that the company does not have
any potential Ior proIitable investments. Furthermore some companies might still be able to
generate at least average return Irom the mature industry. In doing so they are able to produce
positive EVA and thus justiIy their own investments.
It is also important to understand that EVA is beneIicial capital allocation tool not only Ior
shareholders but also Ior the economy in general. EVA is a metric measuring iI the capital is in
eIIicient use considered the return and risk. Positive EVA is a sign that the capital is in eIIicient
%

use considered the risk involved in business. On the other hand capital productivity is one Iactor
aIIecting the whole economy and GDP growth. We have in our economy a certain capital stock
and it produces a certain GDP a year. The more productive our capital is the bigger GDP we
have. Struggling to reach positive EVA is thus not only good Ior shareholders, but it beneIits the
economy and people also in more broad perspective. In practice this beneIicial capital allocation
might mean that excess capital is moved Irom Iorest and steel industry to telecommunication and
soItware industry and it thereaIter enables rapid development with these Iields and drives down
the consumer prices quickly. An overdrawing example: II we had no Iunctioning capital markets
then capital could not move Irom one industry to another. Old industries would keep their capital
and invest all the return back in business. We would thereIore perhaps pay currently a couple oI
percent less Ior our paper and steel but we would still pay 15 000 FIM Ior a 1 kg mobile phone
and 100 000 FIM Ior a PC with 286-processor.


EVA vs. traditional performance measures

Conceptually, EVA is superior to accounting proIits as a measure oI value creation because it
recognizes the cost oI capital and, hence, the riskiness oI a Iirm`s operations (Lehn & Makhija
1996, p.34). Furthermore EVA is constructed so that maximizing it can be set as a target.
Traditional measures do not work that way. Maximizing any accounting proIit or accounting rate
oI return leads to an undesired outcome. Following paragraphs seek to clariIy the beneIits oI
EVA compared to conventional perIormance measures.
EVA, NPV vs. RR, ROI
Return on capital is very common and relatively good perIormance measure. DiIIerent
companies calculate this return with diIIerent Iormulas and call it also with diIIerent names like
Return on investment (ROI), Return on invested capital (ROIC), Return on capital employed
(ROCE), Return on net assets (RONA), Return on assets (ROA) etc. The main shortcoming with
all these rates oI return is in all cases that maximizing rate oI return does not necessarily
maximize the return to shareholders. Following simple example will clariIy this statement:
Suppose a group with two subsidiaries. For both subsidiaries and so Ior the whole group the cost
oI capital is 10. The group names maximizing ROI as target. The other subsidiary has ROI oI
15 and the other ROI oI 8. Both subsidiaries begin to struggle Ior the common target and try
to maximize their own ROI. The better daughter company rejects all the projects that produce a
return below their current 15 although there would be some projects with return (IRR) 12 -
13. The other aIIiliate, in turn, accepts all the projects with return above 8. For a reason or
another (e.g. overheated competition) it does not Iind very good projects, but the returns oI its
projects lie somewhere near 9.
%

Let us suppose that both subsidiaries manage to increase their ROI. With the better subsidiary
ROI increases Irom 15 to 16 and with the not-so-good subsidiary ROI increases Irom 8 to
8,5. The company`s target, increasing ROI, is achieved but what about the shareholder value?
It is obvious that all the projects oI the not-so-good subsidiary decrease shareholder value,
because the cost oI capital is more than rate oI return (and so the shareholders money would have
been better oII with alternative investments e.g. in the markets). But the actions oI the better
subsidiary are neither optimal Ior shareholders. OI course shareholders will beneIit Irom the
good (return over 15) projects but also all 12-13 (actually all above 10 cost oI capital)
projects should have been accepted even though they decrease current ROI. These projects still
create and increase shareholder value.
As the above example demonstrates operations should not be guided with the goal to maximize
the rate oI return. As a relative measure and without the risk component ROI Iails to steer
operations correctly. ThereIore capital can be misallocated on the basis oI ROI. First oI all ROI
ignores the deIinite requirement that the rate oI return should be at least as high as the cost oI
capital. Secondly ROI does not recognize that shareholders` wealth is not maximized when the
rate oI return is maximized. Shareholders want the Iirm to maximize the absolute return above
the cost oI capital and not to maximize percentages. Companies should not ignore projects
yielding more than the cost oI capital just because the return happens to be less than their current
return. Cost oI capital is much more important hurdle rate than the company's current rate oI
return.
Observing rate oI return and making decisions based on it alone is similar to assessing products
on the "gross margin on sales" -percentage. The product with the biggest "gross margin on sales"
-percentage is not necessary the most proIitable product. The product proIitability depends also
on the product volume. In the same way bare high rate oI return should not be used as a measure
oI a company's perIormance. Also the magnitude oI operations i.e. the amount oI capital that
produces that return is important. High return is a lot easier to achieve with tiny amount oI
capital than with large amount oI capital. Almost any highly proIitable company can increase its
rate oI return iI it decreases its size or overlooks some good projects, which produce a return
under the current rate oI return.
The diIIerence between EVA and ROI is actually exactly the same as with NPV (Net present
value) and IRR (Internal rate oI return). IRR is a good way to assess investment possibilities, but
we ought not to preIer one investment project to the other according to their IRR. Assume two
good and exclusive investment projects, project 1 and project 2. Project 1 has lower IRR but is
much bigger in scope (bigger initial investment and bigger cash Ilows and bigger NPV). Project
1 (the project oIIering lower IRR) is better Ior shareholders even though it has lower IRR. That is
because it provides bigger absolute return than project 2. The reason is exactly same as with
ROI: maximizing rate oI return percentage does not matter. What matters is the absolute amount
oI shareholders` wealth added.
%

In the corporate control it is worth remembering that EVA and NPV go hand in hand as also ROI
and IRR. The Iormers tell us the impacts to shareholders wealth and the latters tell us the rate oI
return. There is no reason to abandon ROI and IRR. They are very good and illustrative measures
that tell us about the rate oI returns. IRR can always be used along with NPV in investment
calculations and ROI can always be used along with EVA in company perIormance. However,
we should never aim to maximize IRR and ROI and we should never base decisions on these two
metrics. IRR and ROI provide us additional inIormation, although all decisions could be done
without them. Maximizing rate oI returns (IRR, ROI) does not matter, when the goal is to
maximize the returns to shareholders. EVA and NPV should be in the commanding role in
corporate control and ROI & IRR should have the role oI giving additional inIormation.


Return on equity (ROE)
ROE suIIers Irom the same shortcomings as ROI. Risk component is not included and hence
there is no comparison. The level oI ROE does not tell the owners iI company is creating
shareholders wealth or destroying it. With ROE this shortcoming is however much more severe
than with ROI, because simply increasing leverage can increase ROE. As we all know,
decreasing solvency does not always make shareholders` position better because oI the increased
(Iinancial) risk. As ROI and IRR, return on equity (ROE) is also an inIormative measure but it
should not guide the operations.
Earnings and earnings per share (EPS)
EPS is raised simply by investing more capital in business. II the additional capital is equity
(cash Ilow) then the EPS will rise iI the rate oI return oI the invested capital is just positive. II the
additional capital is debt then the EPS will rise iI the rate oI return oI the invested capital is just
above the cost oI debt. In reality the invested capital is a mix oI debt and equity and the EPS will
rise iI the rate oI return oI that additional capital invested is somewhere between cost oI debt and
zero. ThereIore EPS is completely inappropriate measure oI corporate perIormance and still it is
very common yardstick and even a common bonus base. (No wonder shareholders are not too
Iond oI management bonuses.) EPS and earnings can be increased simply by pouring more
money into business even though the return on that money would be entirely unacceptable Irom
the viewpoint oI owners. EPS, earnings and earnings/EPS growth should thereIore be abandoned
as perIormance measures.


EVA vs. other Value-based measures
Besides EVA there are plenty oI other Value-based or Shareholder value measures. They are
created by consulting industry and/or by academics. Consults are all Iorced to use their particular
%

acronym oI their particular concept although it would not diIIer very much oI the competitors`
measure. Thus the range oI these diIIerent acronyms is wide. Following mentions only a Iew oI
them.
Cash Ilow return on investment (CFROI) is the product oI Boston Consulting Group (BCG) and
HOLT Value Associates. It is the long-term internal rate oI return deIined almost as common
IRR. CFROI is determined by converting proIitability data into gross cash Ilow and using real
gross assets as an implied investment. CFROI is calculated in two steps: First inIlation-adjusted
cash Ilows available to all capital owners in the Iirm are measured and they are compared with
the inIlation-adjusted gross investment made by the capital owners. AIter that the ratio oI gross
cash Ilow to gross investment is translated into an internal rate oI return by recognizing the Iinite
economic liIe oI depreciating assets and the residual value oI non-depreciating assets such as
land and working capital (Myers 1996, p.46).
Cash Value Added (CVA) is very similar to EVA except that it includes only cash items.
Furthermore it keeps the capital costs constant over certain investment period. CVA is the
diIIerence between Operating Cash Flow (OCF) and Operating Cash Flow Demand (OCFD).
OCF is the sum oI Earnings beIore Depreciation, Interest and Tax (EBDIT, adjusted Ior non-cash
charges), working capital movement and non-strategic investments. OCFD represents the capital
costs. It is the average capital cost per year (in absolute terms) that meets the investors` Iinancial
requirements. OCFD is constant over the investment period. (Ottoson & Weissenrieder, 1996)
Shareholder value Added (SVA) is a creation oI Dr. AlIred Rappaport and LEK/Alcar
Consulting Group. It origins Irom the Discounted Cash Flow model and has gained publicity and
established position, although is Iar less used than EVA or CFROI. The idea oI SVA is probably
roughly the same as Rappaport has presented in his book "Creating Shareholder Value" (1986).
That is to discount estimated Iuture cash Ilows to present and hence continuously calculate the
value oI the Iirm. Measuring the current perIormance is based on comparing these cash Ilow
estimates and period`s real cash Ilow (Rappaport 1986, p.183). The exact SVA concept is
unIortunately documented poorly in public sources.
Adjusted Economic Value Added (AEVA) and ReIined Economic Value Added (REVA) are
both slightly modiIied versions oI basic EVA and also both created by academics. Adjusted
Economic Value Added uses current value oI assets instead oI book values (De Villiers 1997,
p.299). ReIined Economic Value Added uses the market value oI the Iirm in the beginning oI the
period instead oI book value (Bacidore et al 1997, p.15).
Unlike EVA many oI these other Shareholder value measures are based more on cash Ilows than
EVA. ThereIore they do not normally suIIer Irom the same imperIections as EVA does. Hence
the rate oI return used with these other metrics is usually a good estimate oI the underlying true
rate oI return without any adjustments. The other side oI the coin is that these other measures are
always quite complicated to calculate. That is the case also with companies that do not need any
%

diIIicult and time consuming adjustments in calculating suIIiciently accurate estimate oI their
true rate oI return. Usually these other value-based measures are also based on more subjective
data than EVA is. At least CFROI and CVA deIer most oI the depreciation into later years in
order to achieve smooth return or smooth capital costs. CFROI includes also some salvage value
in calculations. These Ieatures make the return to divide more evenly between diIIerent periods
but they also make the perIormance measures more subjective. That is because part oI the Iuture
proIit is sort oI brought into the present. The question is ultimately weather it is better to have a
long-term subjective measure or short-term objective measure.
EVA is the most widely used Value-Based perIormance measure (Myers, 1996, p.42) probably
just because it happens to be an easier concept compared to the others. In implementing EVA,
one oI the most important things is to get the people in organizations to commit to EVA and
thereby also to understand EVA (Klinkerman 1997). Even as easy concept as EVA seems to be
quite hard to communicate down the organization. That is why complicated measures do not
work very well.
Some Value-Based measures have been Iound to correlate better with share prices than EVA.
For example (Dodd & Chen 1996, p.26) Iind that Cash Flow Return on investment (CFROI)
explains share price movements better than EVA. OI course EVA can also be modiIied in order
to avoid some accounting distortions and to correlate better with share prices, but then we have
almost as complicated measure as CFROI. The best possible correlation with share prices is not
however the main point, especially when the diIIerences in correlations are quite small and also
disputable. All the shareholder value metrics are said to be identical to discounted Iree cash Ilow
-method, so it is no wonder that some prestigious people say that you can relate the results oI
these metrics "to the Iourth decimal points" (Mayers, 1996, p.45-46 and Storrie&Sinclair 1997,
p. 5). With the complicated shareholder wealth -measures it is not always the toughest part to
communicate these to people, but to calculate these in day-to-day operations. E.g. CFROI calls
Ior taking into account the eIIects oI inIlation to asset values and this in turn takes time and
resources, in other words: it takes money. Hence it can perhaps in many occasions be stated that
the other metrics do not pass a prudent cost-beneIit analysis; the additional costs with
implementing them instead oI EVA are oIten more than the incremental inIormation achieved
with them.


EVA in Group-IeveI controIIing

This chapter discusses how EVA should be deIined and used in Group-level controlling oI
operations. First, it is examined in detail how EVA should be deIined in order to balance
easiness, theoretical correctness and right steering. ThereaIter the chapter deals with arguments
%

Ior and characteristics oI EVA bonus systems. Finally the chapter discusses things that are vital
in implementing phase oI EVA controlling.


A rationaI definition of EVA in business unit management

The most important reason Ior making EVA-concept simpler is to Iacilitate the learning process
oI operating people. There are plenty oI adjustments that make EVA theoretically and/or
practically a better measure or a better guideline in assessment oI diIIerent units. The question is
whether it is worth to do these adjustments or not. Every adjustment increases the complexity oI
the concept although some oI them might be technically Iairly easy to execute. When the
organization has Iirst adopted the basic concept well, it might be good to slightly modiIy the
concept later on.
Avoiding additional costs in drawing the routine reports is also an important reason to simpliIy
the concept. Stewart (1993, p.8) suggests plenty oI adjustments to the basic residual income
concept in order to avoid some accounting distortions. These adjustments include e.g. changes in
depreciation schedule, inIlation adjustments, capitalization oI R&D and other strategic
investments, currency translation etc. As Stewart admits, it is not wise to do all oI these
adjustments because oI the marginal eIIects with some Iields. Many oI these adjustments cost
something by increasing the workload in reporting. The problem whether to make some
individual adjustment to EVA Iigures or not, can be approached e.g. by answering the Iollowing
Iive questions: Will the operating managers understand the change? Will it inIluence their
decisions? How big diIIerence does it make with this company? Can the necessary data be
obtained? How much does it cost?
There can also be other reasons to deviate Irom the theoretically correct way oI calculating EVA
than to only simpliIy the concept. For example, it might be Ior the SBU-managers diIIicult to
realize that equity is costly capital. They might also have an approach that since they have earned
the equity in their balance sheet, they also have the right to use it in their own investments. In
this kind oI situation, it might be useIul - at Iirst, in the early years oI implementing EVA - to
emphasize the cost oI equity capital even with the ways that are not theoretically correct. An
example oI this kind oI procedure is given later in the section 3.1.3. "Average cost oI capital".
The degree oI complexity in EVA can depend on the use oI EVA and also on a business unit`s
accounting systems resources to make the adjustments needed. II a unit has a new and Ilexible
inIormation system which can easily make Iew adjustments to EVA then there is naturally no
need not to do them. However, there are possibly a lot oI units where the accounting systems are
not very sophisticated nor very Ilexible and Ior those units there is a strong need to make EVA as
simple as possible to prevent extra workload Ior internal reporting staII. The cost and beneIits oI
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inIormation should be considered unit by unit or more accurately system by system.


We should perhaps start seeking the practical deIinition oI EVA by examining the individual
terms that EVA consists oI. In Chapter 2.1.2 EVA was deIined with Iormula 2 to be as:
EVA (Rate of return-Cost of capital) x Capital
(NOPAT/Capital - Cost of capital) x Capital
Following paragraphs seek to discuss what the individual terms might include in business
practice.


apital, NOPAT and Rate of return

Stewart (1990) deIined capital to be total assets subtracted with non-interest bearing liabilities in
the beginning oI the period (year). Rate oI return e.g. ROI is however typically calculated as
return on average net assets, because it is a better estimate oI the capital employed than the
beginning capital (Telaranta 1997, p. 26). Although using average capital seems to be estimate oI
the capital employed, the method has also its weaknesses. Average assets include part oI the
return generated during the year. Yet, calculating rate oI return should not include return in the
capital side (in denominator) but only in the return side (numerator). That is because the people
have used to understand and express return in relation to the initial investment and not in relation
to investment's value in the end oI the period. For example an investment in stock markets that
was a year a ago 100 and is now 110 is said to have earned a return oI 10 (10/100) and not a
return oI 9,1 (10/110). Simply excluding the proIit Irom the ending balance sheet in calculating
average assets can prevent this error. In practice the reporting happens at least once a month and
so the average assets can be calculated as average oI individual months instead oI average Irom
the beginning and ending balance sheet.
Net operating proIit (NOP) is quite straightIorward item. OI course it can and should be also
adjusted according to the unique characteristics oI the company in question, but normally there is
no need to that. NOPAT is derived Irom NOP simply by subtracting calculated taxes Irom NOP:
NOPAT NOP x (1-Tax rate). These calculated taxes do not correspond the taxes actually paid
because e.g. interest on debt decreases real taxes. The tax shield oI debt is however taken into
account with the capital costs.
Rate oI return is NOPAT divided by capital, so both the deIinitions oI capital and NOPAT aIIect
rate oI return. As stated in previous chapter, there are some problems in assessing rate oI return
%%

with accounting book values. The rate oI return might be somewhat distorted because oI e.g.
inIlation and it could also be periodized wrongly. Using current value oI assets instead oI book
values can radically reduce the distortions caused by inIlation. This is still not necessarily a
sound procedure because it is surely much more costly and diIIicult than using book values.
Furthermore the beneIits (the changes oI EVA-Iigures into right direction) could be quite small
especially iI the company has a big proportion oI current assets and the economic liIe oI the
Iixed assets is relatively short.
The problem oI wrong periodizing can be remedied with using diIIerent depreciation method in
internal accounting. Normal straight-line depreciation will tend to underestimate the true internal
rate oI return in the early years and overestimate it in the later years. Using an economic
depreciation schedule, known as the "sinking Iund" method, will eliminate this distortion. Under
sinking-Iund depreciation, an asset is written oII in the same way that a banker amortizes the
principal on a mortgage. This means that in the early years most oI the cash the asset generates is
used to provide Ior the return on capital, and only a small Iraction amortizes the capital balance.
In the latter years it is the opposite. This schedule records little depreciation early on and more
later on, but a steady rate oI return and hence EVA is recorded over the liIe oI the asset. Also all
other depreciation methods that weight the depreciation more heavily into the later years will
reduce the problem oI wrong periodizing. However all these methods increase the subjectivity oI
EVA because they sort oI bring some part oI Iuture proIitability into present. Furthermore they
are in most cases unnecessary because with steady capital spending program the periodizing
problem is immaterial. (Stewart 1993, p.15-16)


Taxes in EVA-Iormula

Although taxes are without excess depreciation, increase in reserves etc. about one-IiIth oI the
net income and thus even bigger part oI EVA, they are oIten totally ignored in EVA-control and
reporting. E.g. Lyttyniemi (1996b) considers this as a sound approach. This approach can be
justiIied because taxes are not a part oI operative activities that should be measured and
improved. II the pre-tax EVA is improved, then also the wealth oI shareholders is improved. So
including taxes in reporting does not change the situation in that sense. It only complicates the
concept and calculations. Without taxes the reported income statement is simpler.
However, iI taxes are totally ignored, then the minimum acceptable target can not be that pre-tax
EVA0. In order to achieve EVA0, the pre-tax EVA should naturally be somewhat positive.
This is a disadvantage, particularly iI EVA is used in bonus systems. The bonuses should in that
case be calculated based on the above target EVA. Especially iI the bonus is paid Ior all
employees, the zero target would be desirable. Major part oI the employees can not comprehend
EVA precisely, because they do not know the basic concepts oI accounting and Iinance. On the
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other hand, it is suIIicient Ior them to know that EVA is somehow (but consistently) calculated
net result and iI it is positive, it means bonus. A measure with target as zero is also
psychologically and conceptually better than some other target level even though EVA would
not be used in bonus systems at all.
Taxes in EVA formula according to theory
Normally in calculating EVA taxes are subtracted straight Iorm Net operating proIit and the tax
shield oI debt is taken into account in capital costs:
EVA net operating profit`(1-tax rate) - WACC`capital
This Iormula does not take into account that excess depreciation and reserves oIten decrease the
amount oI taxes paid in real liIe. At least taxes can be deIerred into a distant Iuture. With
continuously growing operations the net reserves increase all the time. The practical tax rate is
thus lower than the nominal tax rate.
Adapted way to calculate taxes
It is not very diIIicult to calculate a good estimation oI taxes paid in the period. This can be done
by simply subtracting the increase in reserves Irom Net operating proIit beIore calculating taxes.
EVA Net operating profit - ((Net operating profit - excess dereciation - other increase
in reserves)`(tax rate)) ] -WACC`capital
This way the taxes are calculated in the same way as tax authorities do it.
Other method that produces about the same result is to decrease the tax rate somewhat according
to the estimated average impact oI increased reserves. The tax rate could e.g. be 20 instead oI
the nominal 28, iI the estimated average impact oI reserves would be something like that. This
is naturally a method oI simpliIication, but might produce a suIIiciently accurate result.
Furthermore it would perhaps decrease Iluctuations Irom year to year in tax component.
When the taxes can be deIerred into distant Iuture, then considering inIlation and the time value
oI money, it is not oI great importance iI they have to be paid ever or not. In this case the
reserves can be viewed as equity and it is reasonable to deduct the increase in reserves Irom net
operating proIit beIore calculating taxes. However, in some occasions the taxes deIerred with
reserves have to be paid quite soon iI e.g. tax regulation changes or iI the company can not do
new investments. Then the reserves can not be viewed as equity.
The connection between deferred taxes in income statement and in balance sheet
The question whether or not to subtract increase in reserves Irom operating proIit when
calculating taxes and the treatment oI deIerred taxes in balance sheet should be linked to each
other. II reserves are noticed in calculating taxes, then the change in deIerred taxes should be
%

treated consistently as proIit and the deIerred taxes in the balance sheet should also be viewed as
equity. This means that deIerred taxes should be attached with capital costs. II the reserves are
not noticed in calculating taxes then the deIerred taxes in balance sheet should consistently be
treated as non-interest bearing tax-debt. This means that they should be subtracted Irom capital
as other non-interest bearing liabilities.
It is diIIicult or impossible to say in advance which oI these two methods reIlects better the
actual situation. However the results oI these two methods are not so Iar away Irom each other:
the other has bigger NOPAT but also bigger capital costs, so the end result (EVA) does not be
that much diIIerent. From the practical viewpoint: it is easier to ignore reserves in income
statement and view deIerred taxes as non-interest bearing debt.


Average cost of capital

As explained in chapter 2, the cost oI capital is deIined as weighted average cost oI both equity
and debt. The tax shield oI debt is noticed with the cost oI debt:
Cost oI capital Cost oI Equity x (Solvency ratio) Cost oI debt x (1- Solvency ratio) x (1-tax
rate)
There are, both in deIining the cost oI debt and the cost oI equity, Iew diIIerent methods and also
some variation in results. They are however mainly estimation problems and are oI little interest
in this context. In other words they do not have anything to do with simpliIying the EVA-
concept or making it a better Iunctioning controlling tool. Some oI these problems are discussed
in chapter 4.
The calculation Iormula oI average cost oI capital (WACC) includes also the solvency ratio. The
solvency ratio usually changes according to business cycles and other Iactors. Financial theory
suggests (Copeland&Weston 1992, p.443-444) that when solvency changes the costs oI the
equity and debt shiIt so much that the WACC itself does not change (or it would not change
without diIIerent tax treatment to debt and equity). When the solvency- or equity-to-debt ratio
decreases, the risk oI equity increases. So when the relative proportion oI debt Irom capital
increases, the return on equity becomes more volatile and thus also the true cost oI equity capital
increases. Also the lenders demand higher premiums on debt when the leverage increases. So
when solvency ratio decreases both the costs oI equity and debt increase and visa versa. The
increase in costs oI equity and debt cancel out the decrease in WACC caused by bigger relative
proportion oI cheaper debt capital. Hence the change in WACC is zero (This is illustrated in
Iigure 2 (Alternative 1) on the page aIter next page.)
%

The reason why average capital costs do not change according to leverage becomes more
intuitive iI we think oI expected returns. Cost oI capital (WACC) reIlects the expected return on
capital with similar risky businesses because it is an opportunity cost i.e. expected return on
similar risky investments. II change in leverage does not aIIect the expected return oI the
company (expected ROI) then WACC can not change. Well it is obvious that expected ROI does
change according to changes in solvency since solvency does not aIIect operating proIit.
Changing only the liabilities-side oI the balance sheet, e.g. replacing equity with debt, does not
aIIect the expected return on assets. The expected ROE in turn changes according to changes in
leverage. Decreased solvency raises expected ROE because increased Iinancial leverage raises
return on equity capital (as well as risk oI equity capital). Similarly the expected return on stock
market does not depend on how the investors Iinance their investments. OI course Ior individual
investor, the expected return changes iI he uses more Iinancial leverage (debt) with his
investment. This aIIects however only return on his own capital (equity) but not the return Ior the
whole investment. Changing leverage changes always the return and risk oI equity and debt
capital but it can not inIluence the underlying expected return oI the whole investment. It merely
allocates the risk and return in a new manner.
Practical perIormance reporting with EVA requires a certain procedure how WACC is calculated
when solvency ratio changes. The Iollowing three examples demonstrate this problem through
three diIIerent procedures to calculate WACC with diIIerent solvency ratios. Examples do not
include the tax shield oI debt in order to keep things simple.
Suppose that the cost oI equity is 15 and the cost oI debt is 5. The target (and normal)
solvency ratio oI the company is 40. How WACC can be calculated when solvency ratio is
30 and 50?
1. Alternative: II we calculate WACC strictly according to Iinancial theory, the costs oI equity
and debt have to be changed each time the solvency changes. This procedure might be too
diIIicult in practical perIormance measurement.
2. Alternative: We can calculate WACC each time with the actual solvency ratio and with the
same estimated costs oI equity and debt. Then WACC changes always according to solvency
ratio and thus the result is not in line with Iinancial theory.
3. Alternative: We can calculate WACC each time with the target solvency ratio no matter what
the actual solvency is. This procedure produces a result in line with Iinancial theory and
additionally it is quite simple.
The Iollowing Iigures will clariIy these three procedures.


%

Figure 3 Alternative 1: WACC is calculated according to financial theory: costs of equity
and
debt change but WACC remains the same when solvency changes.


Figure 4 Alternative 2: WACC is calculated with actual solvency and fixed costs of debt and equity. WACC
thus changes according to solvency. This procedure contradicts with financial theory.


Figure 5 Alternative 3: WACC is calculated with target solvency. WACC remains the same although solvency
changes.
%


As presented earlier the alternatives 1 and 3 are in line with Iinancial theory: WACC can not be
decreased simply by replacing expensive equity capital with cheap debt capital, because
solvency aIIects also the risk level oI both equity and debt capital. ThereIore alternative 2 (using
actual solvency and Iixed debt and equity costs) contradicts with the Iinancial theory and seems
to be out question. Alternative 1 (changing costs oI equity and debt) is best in line with Iinancial
theory, but it requires that equity and debt costs should be scaled according to the prevailing
solvency ratio. In practice it is thereIore too complicated and time-consuming. Alternative 3
(WACC calculated with target solvency ratio) appears to be the best alternative since it is both
simple and in accordance with the theory Ior essential parts. This method does not recognize that
costs oI equity and debt increase with leverage but on the other hand usually only the average
cost oI capital (WACC) is oI importance. Academics and other experts like Stewart (1990, p.85-
89), Lyttyniemi (1996) and Rappaport (1986, p.56) strongly recommend the use oI target
solvency in calculating WACC and EVA.
Optimal capital structure
The above examples ignored the diIIerent tax treatment oI debt and equity and some other
details. In reality the increased tax shield Irom debt decreases WACC somewhat when leverage
increases. ThereIore increasing leverage might decrease WACC slightly. On the other hand iI
leverage increases too much then the increased probability oI bankruptcy and the costs attached
to it increase WACC (Copeland&Weston 1992, p.498-499). These bankruptcy costs increase
rapidly when solvency decreases Irom its already low level. ThereIore low solvency levels are
avoided although mathematically low solvency levels are as good as high since increased return
should compensate the increased risk. Correspondingly bankruptcy costs increase at very
moderate rate when the solvency decreases Irom high level. So it does not have very big
diIIerence with bankruptcy costs iI company's solvency is 90 or 50. However this would
mean a some kind oI change in WACC since it aIIects the tax shield Irom debt Iinancing.
ThereIore very high solvency levels are avoided. Although no completely satisIactory Iinancial
theory has yet been Iound to explain the existence oI optimal capital structure, casual empiricism
%

suggests that Iirms behave as though it does exist (Copeland&Weston 1992, p.536). The changes
in WACC are nevertheless quite small iI the solvency changes moderately and near its optimal
level. II e.g. the solvency ratio oI an industrial company changes between 40 - 50 it probably
has very small impacts on average cost oI capital. That is because only changes in tax shield and
changes in expected bankruptcy costs aIIect WACC and their eIIects are to the opposite
directions. This optimal capital structure does change Irom one business Iield to another. E.g.
real estate companies have on average very low solvency, normal industrial companies have
moderate solvency and rapidly growing high-tech companies have high solvency. These diIIerent
solvency levels reIlect the diIIerences in operational risk levels. E.g. real estate companies have
very smooth operational cash Ilow (rents) so they tolerate more Iinancial risk without too high
bankruptcy costs. This should be remembered also with business unit controlling. The SBUs
with low operational risk might have more Iinancial leverage, lower solvency, than other SBUs.
The calculating oI WACC (and EVA) in business controlling should take into account that there
is some kind oI optimal capital structure. Hence it is not desirable that the solvency ratios oI
SBUs would diIIer Irom it very radically. E.g. iI solvency ratio is a SBU is very high, then the
tax shield oI debt is unused and shareholders will suIIer. Furthermore high solvency ratio means
besides low risk also low return on equity. However shareholders usually want high return Irom
their investments and tolerate the higher risk level - otherwise they would have invested in bonds
instead oI in equity /stock market. SBU managers in turn preIer high solvency to low solvency
because it is easily to operate with high solvency. High solvency enables the company to do the
investments easily without asking Ior equity capital Irom parent company. Furthermore high
solvency gives more discretion since operational cash Ilow does not go to Iixed interest
payments. The companies with high solvency are oIten reIerred as companies with "strong
balance sheet" or as "healthy" companies. Already these expressions reveal that high solvency is
a Iavorable thing.
II EVA reporting and bonus systems are based on Iixed WACC (like example 3 on the previous
pages) then EVA does not decrease no matter what the solvency ratio is. In this kind oI situation
SBU mangers will maintain high solvency and they are not willing to give up excess equity.
Group management can oI course always Iorce the SBUs to decrease their solvency, but it is
quite undesirable situation and leads to lengthy discussions oI the "right" solvency level in
business units. Better solution would be a controlling or incentive system that steers to optimal
(target) solvency. This controlling system can not deIine WACC as it is in the reality. First oI all
it is very diIIicult or impossible to develop a Iormula that would deIine the right WACC at each
solvency level and secondly this Iormula would be diIIicult to use and utmost diIIicult to
communicate throughout organization. ThereIore we have to resort to some kind oI simpliIying
procedure. One possible solution would oI course be to alter the alternative 3, which calculates
WACC with target solvency ratio and Iixed costs oI equity and debt. WACC could e.g. be raised
with 0,5 percentage points or more every time when solvency rises 5 percentage points Irom its
target Iigure.
%

Another possible solution might be to turn back to the "incorrect" alternative 2 which calculates
WACC with actual solvency and Iixed cost oI equity and debt. This procedure could be
complemented with some sanctions iI the solvency Ialls too low. This kind oI system ensures
that SBUs give up their excess equity and they would also understand better that equity is costly
capital. This procedure includes however one major steering Iailure.
A steering failure in using actual solvency ratio
The weighted average cost oI capital (WACC) should be a Iactor steering all the capital
expenditures and investments. All the investments producing a return above WACC (NPV
positive investments) should be executed and all the investments producing a return below
WACC should be rejected. In practice this vital condition does not come true iI the EVA control
uses actual instead oI target solvency ratio in calculating WACC. This is because the high
solvency ratio enables the company to make quite big investments solely with debt capital. In
order to increase EVA, these investments have only to produce a return more than the cost oI
capital.


EXAMPLE oI steering Iailure when WACC is deIined with Iixed costs oI equity and debt and
with actual solvency ratio (alternative 3)
Let us assume that the cost oI debt is 5, the cost oI equity 15, solvency ratio 50 and the
beginning capital 100 (equity 50, debt 50). So the current WACC is 10 50*5
50*15. Let the current return on investment be 11 (operating proIit 11). Thus EVA is (ROI
- WACC)*CAPITAL (11-10)*100 1
The company Iaces an investment, which requires 25 oI capital and oIIers a return oI 6. The
current solvency ratio allows the whole investment to be Iinanced with debt. II the investment
were executed, the new capital base would be 125 (equity 50, debt 75). The new operating proIit
is 11 6*25 12,5 and thus return on investment is 10. WACC would in this new situation
be somewhat lower: 0,4*150,6*5 9 (leverage would change and it would aIIect WACC).
Thus the new EVA would be: (ROI - WACC)*CAPITAL (10-9)*125 1,25
When using the actual solvency ratio, EVA might increase with investments producing less than
WACC as the above example demonstrates. The increase in EVA is due to mixing operating and
Iinancing decisions. The capital resource aIIects EVA calculated with actual solvency. EVA is
simply operating proIit minus capital costs and iI the investment is Iinanced solely with debt,
then the capital costs will only increase with the additional cost oI debt. This pattern enables that
EVA oI a SBU and thus also the management bonuses might increase with accepting investment
projects producing less than WACC. This holds only with short-term and with excess solvency.
In the long run the company has to use debt and equity with target proportions and with already
low solvency it can not solely stick to debt Iinancing. However, the problem must not be
%

underestimated because sometimes people tend to operate in short-term Iocus and SBUs Iace
oIten the situation oI excess solvency. Reserves and accumulated excess depreciation increase
solvency although the net proIit oI a SBU was divided out as group contribution or dividends.


The essence of defining the capital costs accurately
Historically the ROI-targets are set Ior SBUs according to their current perIormance level. II the
current perIormance is good then the ROI-target is also high and visa versa. The board oI
directors in parent company probably wants to include this kind oI pattern also in EVA
controlling. This method, deIining capital costs according to current perIormance level and not
according to the estimated opportunity cost oI capital, is however against the principles oI EVA.
As presented earlier, the whole meaning with EVA is in establishing a capital cost based on risk-
adjusted opportunity cost and that way assuring that the capital is in eIIicient use.
II the capital costs are set too low, it automatically allows the ineIIiciency oI capital. With too
high capital costs the SBUs will ignore some value creating investment opportunities (assuming
that the incentive system is eIIicient). Assume that the cost oI capital is set to be 16 and the
true opportunity cost oI capital is 13. The SBU will ignore all the investment opportunities
producing return between 13 and 16 although they all would improve the position oI
shareholders. The capital Ilows to parent company, which is unable to produce a return above
13. Furthermore, normally most investment possibilities oIIer a return near the capital costs
because we operate in a competitive world. So in this case investments which produce 14 are
Iar more common than investments producing 17.
With ROI-control the high capital costs are grounded with maintaining current high discipline. II
the hurdle rate is decreased, this discipline and the current high proIitability are likely to decline.
This might be worse than ignoring some good investment opportunities. With EVA approach
things are however diIIerent. Imposing capital costs well below current rate oI return does not
leave possibilities to decline current good proIitability without decreasing EVA. That is because
EVA is the absolute amount oI capital the company generates above the capital cost. With EVA
control the capital costs should be estimated as objectively as possible. II and when the company
wants to set challenging targets they ought to introduce them as high EVA targets, not as high
capital costs. There will always be business units with high proIitability or with EVA Iigures
biased upwards because oI depreciated assets. The EVA targets Ior those business units should
oI course be Iar above zero.
Neither the distortions nor wrong periodizing oI EVA should be taken into account in setting the
capital costs. That is mainly because the cost oI capital is used in estimating investment
opportunities with NPV calculations and in this context there are no distortions. Hence modiIied
WACC would cause harm with investment calculations. The distortions in perIormance
%

measurement can be taken into account in EVA Iigures, iI the company is able to estimate their
impact. With steady capital spending program and common asset structure these distortions are
usually immaterial.


EVA in Bonus systems

As discussed earlier EVA might be somewhat distorted because oI inIlation or periodized
unevenly inside diIIerent years because oI Ilat depreciation schedules. Furthermore it has been
presented that these imperIections are exactly the same as problems with accounting rate oI
return (commonly ROI). II ROI were an accurate estimate oI the true underlying return oI an
enterprise, then EVA would also be an accurate estimate oI the excess return to shareholders in
absolute terms. In the normal cases, i.e. with relatively stable investment schedule, normal asset
structure and reasonable investment horizon ROI can be suIIiciently accurate estimate oI the true
rate oI return. Thereby also EVA is accurate enough in estimating the excess return to
shareholders in absolute terms. II that is not the case, then ROI and EVA can be adjusted to
suIIiciently accurate measures with some modiIications. Following paragraphs outline Iirst what
kind oI bonus base EVA would be in the normal case (with no material errors). What the
problems oI ROI/EVA mean Irom the viewpoint oI bonus systems will be discussed aIter that.
Arguments for using EVA in bonus systems

II EVA is zero, the shareholders have earned a suIIicient rate oI return on their capital. Many
Finnish companies have earned negative EVA in the long run (Veranen&Junnila 1997). The
shareholders oI these companies had Ior sure been better oI iI the companies have earned
positive EVA even though some part oI it would have been paid out to company`s managers or
employees. The idea oI EVA bonuses is that iI management can be paid some bonuses, the
shareholders have always earned higher return on their capital than they can expect. This kind oI
bonus system is usually beneIicial both to management and the shareholders, because the
perIormance level is likely to rise aIter introducing EVA bonus system (Wallace 1997).
Motivating bonus system normally encourages managers to exceed the normal perIormance level
and even aIter the payment oI the management`s bonuses, the return to shareholders is more than
it would have been without the bonus system. With well designed bonus plan, the higher the
bonuses that are paid, the better it is Ior the shareholders. EVA bonus paid is Iar Irom a cost to
shareholders, because it is oIten a share in the discretionary value created.
Objective target level
With EVA bonus system the target perIormance level is very objective. Bonus can be paid e.g.
according to some percentage oI positive EVA or according to some percentage oI improved
%%

(positive) EVA. Traditionally bonuses are oIten subjective, because they are based on the
negotiated budgets. The managers negotiating their budgets in turn have incentive to sandbag i.e.
to underestimate their potential perIormance level. That is because revealing the real potential
would mean smaller bonus. With objective and unlimited bonus level, the SBU managers have
an incentive to maximize perIormance and value instead oI sandbagging their potential and
wasting time and eIIort in managing earnings and the expectations oI corporate oIIice. The
Iollowing citations describe the beneIits oI objective bonus system:
Tying incentive compensation to EJA rather than to budget helped streamline the SPX
budgeting and planning processes. No more fussing around in the fall for months, messing
around with a huge planning documents and worrying about sandbagging and things like that. It
is gone, says Chuck Bowman, director of financial planning and analysis. (Kroll1997, p.109)
"...Instead of having budgets drive bonuses, the bonus system ought to drive the
budgets.(Stewart 1990, p. 43)
Agency problems: spending free cash flow
EVA bonus systems are also good in decreasing agency problems. Management oI a subsidiary
wants usually to invest in their business as much as headquarters allows. Not many SBU
management teams conclude voluntarily that they do not have any enough good investment
projects and thus it is better to give the period`s Iree cash Ilow out as dividends. Even iI there
would not be enough good investment projects, the subsidiaries would like to keep the excess
capital in their balance sheet as liquid assets (or invest it in not-so-good projects). With powerIul
(enough motivating and rewarding) EVA-based bonus system the management is aimed to avoid
this kind oI behavior. That is because all capital producing a return less than WACC decreases
their bonuses. II the incentives are tied to the change oI EVA, excess capital in current assets or
overinvestments in mature businesses can do a lot oI harm to bonuses. Wallace (1997, p.15-16)
presents strong empirical evidence showing that aIter introducing residual income based bonus
system, managers avoid investments producing less than WACC. It applies also more generally,
that because EVA measures the ultimate aim oI any company, EVA-based bonus systems unite
the interest oI group management and shareholders or the interest oI group and SBU managers.
Paying managers for performance with EVA-based bonus system
Private entrepreneurs, the managers oI their own Iirm get paid just as they make money. Some
successIul entrepreneurs get rich and there is no set limit to their income level. Corporate
managers can oIten make huge improvements to the wealth oI shareholders since they have large
amount oI capital under management. However mangers are not paid accordingly i.e. with the
line oI the shareholder wealth increases. Even a little improvement in the capital eIIiciency might
imply a big improvement in shareholder wealth in absolute measures. Some oI this kind oI big
improvement should be paid out to managers in order to motivate managers to top achievements
%%

and in order to pay according to perIormance. In practice that would mean paying more than
currently to good perIormers and less to bad perIormers.
A method to link the growth oI productivity to payroll with line-workers
EVA might also be suitable to uniting the interests oI the management/owners and ordinary
employees. There has traditionally been an ever-lasting battle between employees and
employers. It has led to the rise oI strong trade unions and in some cases Iruitless, Irustrating and
wealth-destroying strikes. The problem is that companies` proIits are likely to increase due
productivity growth and employees want always to get their share oI the increased proIit. The
employees do not however exactly know what kind oI share they could have. They also Ieel that
they are always underpaid compared to the salaries oI management and proIits oI shareholders.
ThereIore the demand Ior wage increases are oIten oversized. Economists tell that wage
increases must not be over the growth oI productivity (but that is hard to tell to employees,
because even economists do not always agree on the deIinition oI the productivity). So the raises
oIten go over the growth oI productivity and make proIitability and capital eIIiciency too low
Irom the viewpoint oI owners, which in turn decrease employment. Hence the Iinal suIIerers are
besides shareholders normally also the employees, no matter oI employees` original intention.
EVA-based bonus system might be a way to pay employees according to the change in
productivity. II part oI the positive EVA is always handed over to employees they might be able
to realize the connection between company`s productivity (proIitability) and their own payroll.
In the last resort, the customers and the productivity pay the payroll and not the owners. EVA
bonuses could also bring some elasticity in the payroll oI workers. When the state oI the market
is good the employees get bonuses. When the state oI economy is not so good there are no
bonuses since there are no positive EVA. Good bonuses could prevent, iI negotiated that way,
some oversized wage increase demands. On the other hand, iI wage increases go over the growth
oI productivity it is not possible to reach positive EVA and then there would be no bonus. In that
sense the rise oI the EVA-based bonuses Iollows quite well the increase in company`s
productivity.
With ordinary employees it might be diIIicult to tie the bonus plan to their own achievements
because they can not contribute EVA materially or at least not in a measurable way. It is neither
recommendable to tie the bonus to long run EVA, because it makes the link between company`s
proIit and employees` payroll less visible.


haracteristics of feasible EVA-based bonus system

Noticing long run, EVA-bonus bank

The bonuses Ior corporate managers should always be tied to long run EVA because short term
EVA can sometimes be manipulated upwards to the cost oI long run EVA. The long run can be
incorporated into EVA-based bonuses e.g. by "banking" the bonuses. This would mean that
when EVA is good the managers earn a certain percentage (or other derivative) oI it, but the
bonus should not be paid out to them entirely. E.g. only one third oI the bonus should be paid out
to managers and the rest, two thirds, should be put in a bonus bank. In the Iollowing year
managers earn again a certain bonus and this bonus is also put in the bank and then managers are
paid one third oI the bonuses in the bank. Each year the earned bonuses increase the balance in
bank and managers are paid one third (or what ever the percentage is) oI the accumulated
bonuses. II the periodic EVA based bonus is negative, then the bonus put in the bank is negative
and it decreases the balance already earned. This exposures the managers partly to the risk the
shareholders are used to bear. At the same time it gives golden handcuIIs to the good perIormers
(with big positive balance in the bank) and encourages the bad perIormers (with negative balance
in the bank) to leave the company. Stewart has presented the idea oI bonus bank in his book
(1991, p. 241)
There are oI course some problems in calculating the bonuses in the long run when all oI the key
employees do not occupy the same post Ior many years. For managerial level this should be
however done. Accumulated bonus Irom the current post has to Iollow a manager to the next
post as long as it is inside the group. Retirement in the normal sequence should not aIIect the
bonuses earned but other kind oI leavings should erase the positive balance.
Consistency with bonus system
EVA-based bonuses should be consistent Irom year to year. II management in some SBU earns
big bonuses along with outstanding results, the bonus system should not be altered in order to
reduce these bonuses in the Iuture. OI course Iundamental errors with bonus systems can or
should be corrected but big bonuses per se are not a sign oI these kinds oI errors. On the contrary
big bonuses are a sign oI well Iunctioning bonus system which creates incremental return Ior
shareholders.
Generous bonus from good performance
According to proIessors Michael J. Jensen Irom Harvard Business School and Kevin J. Murphy
Irom University oI Chicago the biggest problem with top management salaries is that managers
are currently paid like bureaucrats rather than like value maximizing entrepreneurs
(Jensen&Murphy 1990, p.1). They also state that traditional bonus systems produce Iar too small
incentives Ior good perIormers and guarantee too big compensation Ior mediocre perIormers
(1990, p.3). Corporate managers have oIten a lot oI capital under their control. Because the
stakes are so high, the potential increase in corporate perIormance and the potential gains to
shareholders are great. The proIessors argued than even though the press oIten wonder the top
management salaries (in the United States), those salaries are certainly not too big on average.

Paying the top management in a more rational manner would eventually mean paying them
according to achievements and with good perIormers that means paying them more than
currently. (Jensen&Murphy1990, p.4).
II the shareholders want that the bonus system has desirable eIIects, the bonuses ought to be
motivating. Positive EVA, iI reached, can and should be truly rewarding meaning that top
perIormers get big bonuses. II however a SBU operates already at positive EVA, the hurdle
should be raised and bonus would Iollow only aIter the target EVA is exceeded. Other possibility
is again to tie bonuses to the change oI EVA. OI course no management team should be
rewarded due to current positive EVA. That would not motivate and it would certainly be
wasting shareholders` money.
The bonuses should not be capped, nor should they have diminishing marginal return. It would
certainly not motivate the mangers to reach Ior stars iI the bonus is limited to certain amount oI
money. Certainly the shareholders would not like to have their proIits to be limited to certain
level either. II the EVA goes to incredible Iigures, the bonuses should Iollow. Bonus system
should neither have limits, nor would it be wise to make the bonuses raise with decreasing rate iI
certain EVA-target is exceeded, because it works in the same way with motivation. The bonus
system should deviate Irom linear only iI it has increasing marginal return: the bigger EVA the
bigger bonus percentage. This kind oI bonus system really motivates the managers to reach the
stars. Furthermore it would be a good way to reduce the problem oI ROI overestimating the true
rate oI return under inIlation.
Changes of EVA more important than absolute values
As presented earlier changes in EVA tie more closely to share prices than absolute values. That
is possible because the changes oI EVA are not as likely to be subject to accounting distortions
etc. as absolute values. Stewart (1993, p.13) suggests thereIore that management rewards are tied
to year-to-year changes in EVA instead oI absolute values. A bonus system based on changes in
EVA emphasizes the Iocus on continuous improvement.
Changes in EVA are in some occasions the only objective way to deIine bonuses. That is
because in a company operating at positive EVA there is no sense paying bonuses based on that
"already earned" EVA. Instead the bonuses can be based on year-to-year changes oI EVA. II
EVA is currently 100 and increases to 120, then the bonus base can be that incremental 20.
In order not to cut Irom the shareholders expected return, the rewards based on EVA changes
should be paid only when the EVA is positive. II bonuses are paid according to changes oI EVA
in a situation where EVA is negative (but improving), the bonus system loses one oI its essential
characteristics. That is: EVA bonuses are never away Irom the expected return to shareholders.
Always tie to the current situation of the SBU

EVA-based bonuses should always be tied to the current situation oI the SBU in question. Unit`s
business liIe cycle should aIIect the goals and thus also the bonus system oI a SBU. Some unit
might have mature line oI business with strong positive periodic EVA and thus imminent danger
oI wasting the ample Iree cash Ilow via overinvestments in mature business. Other unit in turn
might have plenty oI proIitable investment opportunities and good prospects oI long term EVA
although weak current EVA. The bonus system ought to be Iormulated so that it does not Iight
against strategic goals. Sometimes it might be even recommendable not to use any EVA-based
bonus system. II EVA do not Iit in SBU`s current situation it should be leIt out.


The impacts of EVA's imperfections to bonus system

Accounting distortions from inflation and historical values
Because the true rate oI return diIIers oIten somewhat Irom the accounting rate oI return, also
EVA can diIIer Irom the true Economic Value Added. This problem might oIten be insigniIicant
and thereIore ignored. This is the case especially iI current assets make up considerable part oI
total assets or iI the investment horizon oI the company is relatively short. II however these
distortions have material eIIects in EVA, there are at least a couple oI ways to circumvent the
problem. Firstly according the assets structure, inIlation rate and investment horizon the extent oI
this problem can be estimated and hence the bonuses can be tied to the estimated target EVA,
which corresponds the zero EVA in real terms. Second possibility is oI course always to tie
bonuses to the periodic changes in EVA instead oI absolute values. The distortions in these
periodic changes are so insigniIicant that they can be ignored. Third solution would be bonus
system with increasing marginal compensation. Bonus percentage can be small at low levels oI
EVA but increasing when EVA increases. This kind oI pattern decreases the eIIects oI inIlation
biasing EVA upwards. Furthermore it has other appealing Ieatures like more motivation to top
achievements.
The problem of wrong periodizing
II a company has depreciated almost all oI its Iixed assets, it might have - prior adjustments - big
positive EVA even though the business would on average and in the long-run produce
unsatisIactory true rate oI return. In a similar Iashion, iI a company has a lot oI undepreciated
new assets in its balance sheet, it might show negative EVA even iI the business would be quite
proIitable in the long run. OIten businesses have steady growth and hence the above problems
are luckily quite rare. II however EVA is unevenly periodized it has to be taken into account with
bonus systems.
The problem oI wrong periodizing can appear with diIIerent time horizons. The problem might
be either chronic or temporary. II the problem is only temporary and will become even in couple

oI years, then merely emphasizing long run with the bonuses would solve problem. An example
oI chronic wrong periodizing would be e.g. old paper mill where the initial and massive
investments in the Iactory are already depreciated totally. Another example is
telecommunications operator that continues to invest in inIrastructure and keeps making very
small accounting proIit or even loss in the near Iuture. For both companies ordinary EVA bonus
is clearly unsuitable and would not steer the operations correctly. The Iormer (old paper mill) can
however use EVA bonus system or actually that kind oI bonus system is quite suitable Ior it. One
solution Ior bonus system Ior this mill is to take only the change oI EVA as bonus base. That
way the managers oI the mill have an incentive to drag out as much Iree cash Ilow as they
possibly can. That is also the best way to operate Irom the viewpoint oI the shareholders. The
Iormer company (teleoperator investing heavily) is probably unsuitable Ior any kind oI EVA
bonuses. Tying bonuses to changes in EVA would not work because EVA can be increased
simply by decreasing long-term investments.
The problem oI wrong periodizing in bonus systems can also be prevented by directly deIerring
some or all capital cost Ior some major investment. This is especially practical iI the problem
arises Irom one or two major new investments.
Although EVA has some imperIections they seldom outdo the beneIits oI EVA-based bonuses.
Even in situations where EVA or bonus system is not adjusted to these imperIections the change
in the approach and the behavior oI management is great. II the SBU managers know how to
operate in order to enhance shareholder value and they are also motivated to act accordingly
because oI good bonus systems, then some minor estimating errors with EVA Iigures do not
matter. The most essential thing with EVA is however the Iundamental change to adopt some
kind oI Shareholder value approach. Empirical research (Wallace 1997) and plenty oI examples
(e.g. Gee 1997, p.7; Kroll 1997, p.109; Martin 1996, p.173) support the argument that adopting
EVA or any Residual income based compensation plan beneIits the shareholders.


Possible EVA-based bonus plans
This section seeks to summon up the discussion about the implications oI EVA`s imperIections
to bonus systems. This is done by presenting some possible bonus patterns in diIIerent kind oI
companies.
Example 1
A typical industrial company has both new and old assets and is growing steadily. The company
operates currently at small negative EVA (on average). EVA based bonus plan should be
constructed so than it encourages reaching positive EVA and improving the perIormance
continuously. Plan should also discourage making NPV negative investments.

Possible bonus system
Amount oI bonus earned Ior each year:
Absolute EVA ` Z + Periodic change in EVA ` 5 ` Z
The amount oI bonus will be put in bonus bank every year. The bonus paid is / oI the current
balance in the bank. Change oI EVA will increase bonus only iI the EVA is positive. Improving
negative EVA does not bring any bonus unless EVA increases above zero.
Example 2
An old business unit produces positive EVA all the time. The good proIitability is however
partly due to the Iact that the company`s Iixed assets are mainly depreciated. Thus the capital
costs are very small and the accounting rate oI return overestimates the true rate oI return.
And:
Example 3
A recently acquired business unit operates at a new business area. For some reason the current
proIitability is very good even though the unit has mainly new assets.
Possible bonus systems (for Examples and 3)
Amount oI bonus earned Ior each year:
Change in EVA ` Y
Or
Amount oI bonus earned Ior each year:
(EVA - Target EVA) ` Z + Change in EVA ` 5 ` Z
The amount oI bonus will be put in bonus bank every year. The bonus paid is / oI the current
balance in the bank. "Target EVA" can be e.g. current EVA or current EVA plus something or
some other EVA level determined by group managers.
Example 4
A new business unit operates at a new business area. In order to succeed in the Iuture the unit has
to make heavy investments. Furthermore the made investments are expected to produce big
positive cash Ilows only in the coming years. Hence currently the unit operates at a very small
net proIit and at big negative EVA.
Possible bonus systems

EVA based bonus system is not suitable Ior this unit because oI its growth phase and long
investment horizon.


mpIementing EVA controI inside organization
Implementing EVA is and at least should be more than just adding one line in the monthly proIit
report. EVA aIIects the way capital is viewed and thereIore it might be some kind oI change in
management`s attitude. OI course this depends on how shareholder value Iocused the
management and the company has been in the past. While implementing EVA represents some
kind oI change in organization, it should be implemented with care in order to achieve
understanding and commitment.


Understand and tailor to your company
It is vital that group level managers gain Iirst thorough understanding Irom the characteristics oI
the concept, how these characteristics aIIect controlling and above all, in what kind oI situation
the SBUs are currently Irom the viewpoint oI these characteristics. BeIore implementing EVA to
any SBU, the group management ought to assess whether the business units are currently cash
Ilow generators in mature businesses or companies in rapidly growing businesses. This
assessment should absolutely include careIul estimation oI the relative age and structure oI the
assets in order to know whether the current accounting rate oI return is over- or underestimating
the true rate oI return. Only thereaIter can the concept be properly tailored to the unique situation
oI each individual business unit. The group level managers ought also to know how to support
the strategic goals oI a SBU with EVA and how to create value with EVA in this individual
SBU. According to John Shiely, the CEO oI Briggs & Stratton Corp, "Adopting EJA simply as a
performance measurement metric, in the absence of some ideas as to how youre going to create
value, isnt going to get you anywhere." (Kroll 1997, p.109).
Gaining understanding and commitment at SBU level important
At the SBU level gaining understanding and commitment are also the most important issues.
First task is to get the support oI all the managers, not only oI the managing director and
treasurer but also oI directors oI production, marketing, sales etc. This is achieved with intense
and thorough training. For managerial level attaining heavy commitment can be Iacilitated very
much by introducing good incentive plan based on EVA.
Gaining commitment oI the middle managers and other employees below the top management oI
a business unit is also important. Training and some kind oI EVA-based compensation plans
should also be considered with these target groups.

Other things to remember in implementing EVA
Keeping EVA simple is also viewed as an important Ieature in successIul implementation
(Gressle 1996). In principle EVA is a simple concept and like that it should be also oIIered to
business units. In some cases it is even possible to simpliIy the current complex periodic proIit
reports by excluding some insigniIicant ratios. EVA summons up some important aspects oI
Iinance and value creation. Thus EVA might also give proIound Iinancial understanding to some
operating people (sales, production) not Iamiliar with these issues and conIused about current
great number oI diIIerent Iinancial measures.


EVA in case-SB&

This part oI the study is not publicly available.


Summary and concIusions

Economic Value Added is a residual income variable. It is deIined as Net operating proIit aIter
taxes subtracted with the cost oI capital tied in operations. Standard EVA corresponds
mathematically the standard DCF Iormula because it is a modiIied version oI DCF. EVA`s
equivalence with DCF and NPV holds in valuations although DCF and NPV are based only on
cash Ilows and EVA is based also on historical accounting items. This peculiar characteristic oI
EVA is due to the Iact that book value is irrelevant i.e. it can be canceled out in valuation
Iormula oI EVA. In periodical perIormance measurement EVA can however in some occasions
give misleading inIormation because it suIIers Irom the same shortcomings as accounting rate oI
return (ROI). InIlation can distort the values oI EVA. Furthermore EVA suIIers Irom wrong
periodization. In most cases the impacts oI these shortcomings are however Iairly small. They
can also usually be eliminated Ior major parts with some corrective adjustments.
In spite oI its Iaults, EVA seems to have importance Ior companies as a perIormance
measurement and controlling tool. First oI all it is Iairly simple measure but still measures well
the ultimate aim oI any given company, the increase or decrease in shareholders` wealth.
Maximizing traditional perIormance measures like ROI is not theoretically in line with
maximizing the wealth oI shareholders. ThereIore EVA is superior to conventional perIormance
measures. The premise behind EVA that businesses must cover their capital costs is neither
new nor peculiar. Putting it into practice can still be eye-opening. EVA shows Iinancial
perIormance with a new pair oI glasses or oIIers new approach especially Ior the companies

where equity is viewed as Iree source oI Iunds and perIormance is measured by some earnings
Iigure. At best EVA helps with creating a mind-set throughout the organization that encourages
managers and employees to think and behave like owners.
At operational level this new approach leads oIten to increased shareholder value through
increased capital turnover (Wallace 1997, p.16). In many companies everything has been done in
cutting costs but the capital eIIiciency has been ignored. EVA has been helpIul because it Iorces
to pay attention to capital employed and especially to excess working capital. Allocating the
capital costs to their originators i.e. individual Iunctions oI organization can Iurther reinIorce this
impact.
One oI EVA's most powerIul Ieatures is its suitability to management bonus systems. This have
been empirically prooIed to be good way to increase shareholder value (Wallace 1997). The
good Ieasibility Ior this purpose is due to the nature oI EVA as excess return to shareholders.
When EVA is maximized also shareholder value is maximized. The idea oI EVA bonuses is that
iI management can be paid some bonuses, the shareholders have always earned higher return on
their capital than they can expect. This kind oI bonus system is usually beneIicial both to
management and the shareholders, because the perIormance level is likely to rise aIter
introducing EVA bonus system. EVA bonus paid is Iar Irom a cost to shareholders, because it is
oIten a share in the discretionary value created. With well designed bonus plan, the higher the
bonuses that are paid, the better it is Ior the shareholders. In order to be successIul, EVA based
bonus systems should be long-term, based mainly on changes oI EVA and oIIer considerable
bonuses Ior considerable shareholder value improvements.
With implementation it is important to understand the EVA-concept thoroughly and tailor the
concept to the unique situation oI each company or business unit. EVA is at its best as an overall
measure and organizational approach with strong link to payroll oI managers and other
employees. That kind utilization can not succeed without deep understanding and commitment
achieved with proper training.
Substantial shareholder value increases and true success stories arise always Irom outstanding
strategy, quick response, great ideas and good predicting oI Iuture. EVA helps in quantitative
assessing oI diIIerent strategies but that is all. Wealth does not arise Irom EVA alone. EVA only
measures changes oI wealth. It is also as short-term as all other periodic perIormance measures.
ThereIore all companies should rely also on other perIormance measures. Especially important
this is e.g. Ior new growth phase companies. However we have to bear in mind that the success
or Iailure oI any given company is measured ultimately as created shareholder value. ThereIore
EVA is important measure also Ior those companies that use primarily other tools is assessing
the achievement oI their strategic goals.
Author:
Esa Mkelinen
%

E-mail: www.evanomics.com
Helsinki School oI Economics, Finland
February 9th 1998




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Author:
Esa Mkelinen
E-mail:
www.evanomics.com
Helsinki School oI Economics, Finland
February 9th 1998